Why diversify?

While diversification can't guarantee a profit or prevent a loss, it can help balance risk and reward with your hard-earned money.

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Your music playlists aren't just one artist on repeat. And neither is that mix of nutrients you're packing into your favorite lunchtime burrito. Diversity is at the core of your daily life—and it's just as critical to your finances.

Diversification in investing is the practice of spreading your investments around, resulting in 3 core benefits: 1) minimizing risk because your exposure to any one type of asset is limited; 2) avoiding short-term mistakes by lowering fluctuations that can be caused by a single asset; and 3) earning long-term value by capturing gains from a bunch of assets.

While diversification can't guarantee a profit or prevent a loss, it balances risk and reward with your hard-earned money. Here are the 4 primary components of a diversified portfolio you should know:

Ways to diversify

Domestic stocks

Tossing on your preferred workout gear? Just back from your grocery store chain of choice? You can own equity in the US-based companies you enjoy by buying their shares in the stock market. Stocks are the most aggressive part of your portfolio, providing the opportunity for higher growth over the long term. But with greater potential gain comes greater risk—stocks are generally more volatile than other assets as their value fluctuates with trading. So you can further diversify within this asset class by purchasing stock in companies in various industries.

International stocks

Don't limit your stock friendship to just Uncle Sam—foreign companies also issue stock. Owning international stocks provides exposure to opportunities not offered by US companies, as shares of an Indian pharmaceutical company or Brazilian energy conglomerate will give you financial access to those growing markets.

Bonds

The "b" in bonds doesn't stand for "boring," but they are generally less volatile than stocks. Bonds can provide regular interest income and cushion against stock market volatility because they typically behave differently than stocks. Investors who are more focused on safety than growth often favor high-quality bonds (like "Treasurys" guaranteed by the mighty US government), accepting lower long-term interest returns because bonds are lower risk. But riskier bonds (like international bonds from developing countries) will offer higher yield for their greater risk.

Short-term investments

You'll need to park that extra cash somewhere, and it might as well be in a more stable investment, but still earn interest. For those looking for a minimal risk asset, money market funds and short-term CDs (certificates of deposit) are conservative investments that offer stability and easy access to your money. In exchange for that level of safety or stability, money market funds usually provide lower returns than bonds, but neither the Federal Deposit Insurance Corporation (FDIC) nor the fund's sponsor (like Fidelity) insures them. While CDs are insured, they are less liquid and require 3-month, 6-month, or even annual commitments to not withdraw your cash.

You could lose money by investing in a money market fund. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Before investing, always read a money market fund’s prospectus for policies specific to that fund.

Now here's how you can uber-diversify:

  • Sector funds
    Need exposure to "tech" or "consumer goods" stocks? Sector funds invest in a variety of stocks focused on one industry in the economy. Because of their narrow focus, sector funds tend to be more volatile than funds that diversify across many sectors and companies.
  • Commodity-focused funds
    Since experienced investors are licensed to trade commodities like oil, gas, sugar, or even cocoa beans, you can gain exposure to them through equity funds that invest in commodities.
  • Real estate funds
    It isn't exactly easy to buy a chunk of land to get exposure to the real estate market, so you can do so through real estate investment trusts (REITs) that purchase and bundle a variety of buildings, apartments, or land. Changes in real estate values or economic downturns can have a significant negative effect on issuers in the real estate industry. The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.
  • Asset allocation funds
    We know—you're busy. So if you don't have time or experience diversifying, you can buy asset allocation funds. Fidelity even manages a number of different types of these funds with specific goals and strategies, like target dates or income-generation income.

Conclusion

Forget popping some headache medicine, because diversity helps minimize the pains of volatility. The more aggressive and less diverse portfolio below (70% domestic stocks) suffers great fluctuation, with higher highs (up 163% one year) and lower lows (down 68% another), resulting in an average annual return of 10%. But adjusting the asset allocation to 49% domestic stocks for greater diversity of assets tightened those jumps-n-drops and resulted in a similar average annual return of 9%. While a diverse asset allocation can't guarantee success, it can help make the road a lot less bumpy.

Next steps to consider

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