Please ensure Javascript is enabled for purposes of website accessibility

Understanding Portfolio Diversification

A look at how to build a diversified portfolio.

By Matthew DiLallo – Updated Mar 13, 2023 at 1:43PM
A hypothetical example of a diversified portfolio that invests in a variety of industries, countries and market caps.
Image source: The Motley Fool

Most people have heard the old saying, "Don't put all your eggs in one basket." The logic: If a farmer were to stumble while bringing the basket of eggs back from the henhouse, they could end up with a messy situation. Those words of wisdom go well beyond farming; they also perfectly encapsulate the idea of not risking all your money on a single investment.

One way investors can reduce their risk of a cracked nest egg is by diversifying their portfolio. Here's a look at what that means, as well as three tips to help you quickly diversify your investments.

What is portfolio diversification and why does it matter? 

A diversified portfolio is a collection of different investments that combine to reduce an investor's overall risk profile. Diversification includes owning stocks from several different industries, countries, and risk profiles, as well as other investments such as bonds, commodities, and real estate. These various assets work together to reduce an investor's risk of a permanent loss of capital and their portfolio's overall volatility. In exchange, the returns from a diversified portfolio tend to be lower than what an investor might earn if they were able to pick a single winning stock. 

What goes into a diversified portfolio? 

A diversified portfolio should have a broad mix of investments. For years, many financial advisors recommended building a 60/40 portfolio, allocating 60% of capital to stocks and 40% to fixed-income investments such as bonds. Meanwhile, others have argued for more stock exposure, especially for younger investors.  

One of the keys to a diversified portfolio is owning a wide variety of different stocks. That means holding a mix of tech stocksenergy stocks, and healthcare stocks, as well as some from other industries. An investor doesn't need exposure to every sector but should focus on holding a wide variety of high-quality companies. Further, investors should consider large-cap stockssmall-cap stocksdividend stocksgrowth stocks, and value stocks

In addition to owning a diversified stock portfolio, investors should also consider holding some non-correlated investments (e.g., those whose prices don't ebb and flow with the daily gyrations of stock market indexes). Non-stock diversification options include bonds, bank CDs, gold, cryptocurrencies, and real estate.

Three tips for building a diversified portfolio 

Building a diversified portfolio can seem like a daunting task since there are so many investment options. Here are three tips to make it easy for beginners to diversify.  

1. Buy at least 25 stocks across various industries (or buy an index fund)

One of the quickest ways to build a diversified portfolio is to invest in several stocks. A good rule of thumb is to own at least 25 different companies.

However, it's important that they also be from a variety of industries. While it might be tempting to purchase shares of a dozen well-known tech giants and call it a day, that's not proper diversification. If tech spending takes a hit due to an economic slowdown or new government regulations, all those companies' shares could decline in unison. Because of that, investors should make sure they spread their investment dollars around several industries.

One quick way to do that for those who don't have the time to research stocks is to buy an index fund. For example, an S&P 500 index fund will aim to match the S&P 500's performance. The benefit of index funds is that they take a lot of guesswork out of investing while offering instant diversification. For example, with an S&P 500 index fund, you're buying shares of a single fund that gives you exposure to 500 of the largest public U.S. companies.

Another great thing about index funds is that their fees -- known as expense ratios -- are very low. That's because with index funds you're not paying for the expertise of a fund manager who's going to research and hand-pick investments for you.

2. Put a portion of your portfolio into fixed income

Another important step in diversifying a portfolio is to invest some capital in fixed-income assets like bonds. While this will reduce a portfolio's overall returns, it will also lessen the overall risk profile and volatility. Here's a look at some historical risk-return data on a variety of portfolio allocation models:

Data source: Vanguard. Return data from 1926 to 2018.
Portfolio Mix Average Annual Return Best Year Worst Year Years with a Loss
100% bonds 5.3% 32.6% -8.1% 14 out of 93
80% bonds and 20% stocks 6.6% 29.8% -10.1% 13 out of 93
40% bonds and 60% stocks 8.6% 36.7% -26.6% 22 out of 93
20% bonds and 80% stocks 9.4% 45.5% -34.9% 24 out of 93
100% stocks 10.1% 54.2% -43.1% 26 out of 93

Although adding some bonds reduces a portfolio's average annual rate of return, it also tends to mute the loss in the worst year and cut down on the number of years with a loss.

While picking bonds can be even more daunting than selecting stocks, there are easy ways to get some fixed-income exposure. One of them is to buy a bond-focused exchange-traded fund (ETF). 

3. Consider investing a portion in real estate 

Investors who want to take their portfolio diversification to another level should consider adding real estate to the mix. Real estate has historically increased a portfolio's total return while reducing its overall volatility.

An easy way to do this is by investing in real estate investment trusts (REITs), which own income-producing commercial real estate. The sector has an excellent track record. In the 25-year period ending in 2019, REITs, as measured by the FTSE Nareit All Equity REIT Index, outperformed the S&P 500 in 15 of those years and generated an average annual total return of 10.9%.

Several studies have found that an optimal portfolio will include a 5% to 15% allocation to REITs. For example, a portfolio with 55% stocks, 35% bonds, and 10% REITs has historically outperformed a 60% stock/40% bond portfolio with only slightly more volatility while matching the returns of an 80% stock/20% bond portfolio with less volatility. 

Related investing topics

Diversification reduces the risk of cracking your nest egg

Diversification is about trade-offs. It reduces an investor's exposure to a single stock, industry, or investment option. While that can potentially cut into an investor's return potential, it also reduces volatility, and, more importantly, the risk of a bad outcome. Investors should take diversification seriously. Otherwise, they're taking a big gamble that an outsized bet won't spoil their hopes of expanding their nest egg to support them in their golden years.

The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over Half a Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 03/24/2023.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.