When setting up your portfolio, you may wonder whether you are choosing the right mix of investments. In fact, you’ve probably heard that owning a well-diversified portfolio is key—but what does that mean?
Essentially, diversification means owning many different types of investments. But the accent here is on owning different investments, as the variety is key to your long-term goals. If all you own is 10 stocks, for instance—especially if they’re concentrated in the same sector, region or market-cap range—you’re not really diversified at all.
When your portfolio is well-diversified across various asset classes such as stocks, bonds, commodities and cash, the right mix can help protect your portfolio from bumps in the market. A broadly diversified portfolio is designed to have some assets perform well when others lag. Over time, that counterbalance tends to give you better results than having your whole portfolio ride on one type of investment—which is why owning 10 stocks per se, won’t deliver the diversification you need.
Why diversification is valuable
A portfolio with a basic combination of stocks and bonds is likely to perform better over time than a portfolio of stocks alone.
Stocks are represented by total annual returns of the S&P 500 Index, bonds are represented by total annual returns of the Bloomberg Barclays U.S. Aggregate Bond Index, and cash is represented by total annual returns of the FTSE Treasury Bill 3 Month Index. The portfolio is rebalanced annually. Returns include reinvestment of dividends, interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Diversification does not eliminate the risk of investment losses. Past performance is no indication of future results.
Source: Schwab Center for Financial Research, with data provided by Morningstar, Inc.
Yes, stocks are important for growth. But bonds can act as buoys that help prevent your portfolio from sinking as low as it might when stocks run into a major storm. For example, in 2008 when stocks lost 37%, core bonds gained 5%. So although diversification doesn’t eliminate volatility, it can help to lessen the blow.
While this example helps to illustrate the long-term value of being diversified, you don’t want to stop at the basic stock-and-bond level of diversification.
Within stocks you can invest in companies of varying sizes, international companies and those in different sectors—like consumer staples, technology or energy. With bonds, you have different types of issuers—governments, blue-chip companies and municipalities. You may also want to consider commodities or non-traditional investments, like real estate investment trusts (REITs). And cash, which is typically the least correlated with other asset classes, can play a key defensive role in your portfolio.
The challenge of diversification
Now, given the many thousands of investments available in each asset class, how do you choose the right ones? These days, you have the ability to use exchange-traded funds (ETFs) as tools to help diversify your portfolio. Like mutual funds, ETFs contain many securities.
The more securities you own within any asset class, the more diversification you have. It’s true that having a portfolio of 10 stocks is wiser than owning just one or two stocks, but it pales in comparison to the diversification you get from owning an ETF, which typically has at least a few dozen securities. Build a globally diversified portfolio of multiple ETFs across different asset classes, and you will own shares of hundreds, if not thousands, of individual securities.
Decades ago this would have been costly (if not impossible) for an individual to pull off. But the inherently lower cost of ETFs makes diversification extremely cost-effective.
What You Can Do Next
Whether you’re setting up a portfolio for the first time or a seasoned investor, make sure you have the right mix of investments that matches up with your financial goals.
- A robo-advisor like Schwab Intelligent Portfolios® leverages the power of diversification by investing in up to 20 different asset classes across stocks, bonds, commodities and cash—all selected by a team of Schwab investment experts. Complete a brief questionnaire to build a portfolio in line with your goals and risk tolerance.
- If you prefer more personalized guidance, consider Schwab Intelligent Advisory™. A Certified Financial PlannerTM professional can help you fine-tune your financial plan.
- Call us at 800-355-2162 or visit your local branch to discuss your asset allocation.