A diversified stock portfolio is key to long-term investing success. By spreading your investments, you can reduce your overall risk and increase your chances of steady returns over time. This means that during periods of market volatility, you are less likely to be impacted by dramatic fluctuations in prices.
Here are some tips for building and maintaining a properly diversified portfolio.
Start with Asset Allocation
Asset allocation refers to dividing your investments across the major asset classes, including stocks, bonds, and cash equivalents. This helps insulate your portfolio from market swings. A common starting point is having 60% in stocks, 30% in bonds, and 10% in cash, adjusting the percentages based on your risk tolerance and investment timeline.
When building a diversified portfolio, it’s important not just to diversify across asset classes but also within each individual asset class. For stocks, you’ll want to diversify by market capitalization, sectors, investment styles, and geography as mentioned previously. For bonds, incorporate government and corporate bonds with short, intermediate, and long durations. With cash equivalents, use a mix of money market funds, CDs, and short-term Treasury bills.
The goal is to mitigate risk by reducing correlated exposures so that no single security or category of securities disproportionately impacts your portfolio. Spreading your investments across varied sub-categories provides stability.
Diversify Your Stock Holdings
If you are investing in stocks, diversification is critical. You’ll want exposure to stocks across market capitalizations, investment styles, sectors, and geographic regions. Blend large-cap, mid-cap, and small-cap stocks to balance stability and growth. Complement value stocks with some growth stocks.
Invest across non-correlated sectors, such as technology, healthcare, financials, and consumer staples. This reduces sector-specific risk. For example, if you are interested in technology, jump into AI focused stocks, and then diversify with stocks from healthcare. It’s also wise to have some international stock exposure, including both developed and emerging markets. Many investors make the mistake of focusing solely on U.S. stocks.
Choose Broad Market Index Funds
One of the best ways to achieve diversification is by investing in broad market index funds. These provide instant diversification by tracking major indexes like the S&P 500. When you invest in an S&P 500 index fund, you gain exposure to 500 of the largest U.S. companies across multiple sectors and industries in one fund.
Some other popular index funds include total stock market funds, international stock funds, bond funds, and more targeted sector-specific funds. Index funds offer built-in diversification at low cost while requiring minimal maintenance.
Complement with Individual Stocks
In addition to index funds, you may want to selectively invest in individual stocks to overweight certain sectors or profit from specific growth opportunities. Just be sure to limit individual stock positions to 5-10% of your overall portfolio so any one stock can’t significantly hurt your returns.
Diversifying individual stock holdings involves analyzing the stocks’ correlations and avoiding too much overlap. For example, owning shares in multiple internet companies would overexpose you to that sector. It’s better to blend stocks across less correlated sectors.
Rebalance and Readjust
As market conditions shift over time, your portfolio asset allocation will drift from your target. Rebalancing brings your portfolio back in line with your original asset class goals. Rebalancing also forces you to sell high and buy low. Readjust your portfolio at least annually or when allocations skew more than 5-10% from desired levels.
Building a properly diversified portfolio takes some research and maintenance, but doing so can smooth out volatility and position you for the best possible long-term returns. The keys are allocating across major asset classes, diversifying stocks broadly, utilizing low-cost index funds, limiting individual stock positions, and rebalancing at least annually. With a thoughtful diversification strategy, you can reduce risk and achieve your investing goals.