How diversification can help lower risk

You’ve heard the advice, “Don’t put all your eggs in one basket.” But think about why that's not recommended. The heavy basket could break. The eggs could crack. There are so many potential mishaps that could be avoided by having a few more baskets on hand. That’s how diversification works. It doesn’t eliminate an investor’s risk, but it can reduce the chance of everything falling apart.

Embrace the unknown

You might enjoy following the market and researching companies. But anyone who watches the market has seen a single stock’s value rise or fall rapidly. It could be because the market had a good or bad day or because the company showed a profit or loss. Also, stock markets usually have an inverse relationship with bond markets. When one is down, the other might be up — or at least not down as much.

It’s impossible to predict which company, industry, region or investment type (known as asset class) will do well in any given year. With a diversified portfolio invested in a range of options, you don’t need a crystal ball. If some holdings suffer a setback, other investments may help compensate for that loss. Diversification may not boost your overall return, but it can help your portfolio fluctuate less.

Find a basic balance

Many investors start by dividing their money among investments that historically haven't moved in the same direction. You might hold some stocks, some bonds and some cash.

Stocks can be riskier, but they have often provided higher long-term returns. Bonds typically pay regular income and haven't gone up and down as much in value. Generally, they are considered more conservative investments than stocks, with lower rewards. How much you own of each will depend on your personal goals and when you need to access your money.

You can diversify even further within each type of investment by owning more than one type of stock or bond. Companies of different sizes might have different results. Different bond types carry different degrees of risk and return. Holding international stocks or bonds can help offset the risk of focusing on a single region’s economic condition. Keep in mind that investing outside the U.S. involves its own risks, including currency fluctuation and price volatility.

Consider your options

A mutual fund makes it possible to invest in many companies or types of bonds because it bundles a collection of investments. There are many types of mutual funds, but you could start looking at them by category. There are stock mutual funds that focus on different parts of the market, as well as bond mutual funds that invest in specific types of bonds.

Stock funds may invest according to:

• Company size: Mutual funds may invest in large, medium and small companies. Those that invest in big, well-known companies are large-capitalization (large-cap) funds. Small-cap funds invest in new, rising companies. Mid-caps fit somewhere in between. Note that small-company stocks entail additional risks, and they can fluctuate in price more than larger company stocks.

   

• Sector: A mutual fund may focus on a single industry. Sectors include technology, health care or utilities, for example.

   

• Region: Some funds invest within the United States. Others look for opportunities around the world.

   

Types of bond fund investments:

• Government bond funds invest in bonds backed by the U.S. Treasury or other U.S. government entities.

   

• Mortgage-backed bond funds invest in pools of mortgage debt sold by banks or federal institutions.

   

• Municipal (muni) bond funds invest in projects backed by certain states or municipalities. If your town builds a new bridge, for example, it may use muni bonds to pay for it.

   

• Corporate bond funds invest in company debt. When corporations want to raise money without issuing stock, they can use bonds as a way of borrowing money from investors.

   

• International and global bond funds invest in bonds from governments and companies around the world.

Spread the wealth

If you own many mutual funds but they’re all in the same category, that’s not diversification. A diversified portfolio spreads your money over different asset classes. In the stock portion of your portfolio, a U.S. fund will tend to perform differently from an international fund. A large-cap fund may balance some of the exposure of a small-cap stock fund. You may want to own government bonds to help provide a measure of stability and municipal bonds for tax-exempt income, in addition to corporate bonds for income and so on.

And you can’t predict how each asset class will do year to year. Emerging markets, for instance, may have the highest returns one year, but U.S. stocks might be the place to be in the following year. Next year: Who knows? You can see why it makes sense to hold investments in more than one category. Learn more about asset allocation to understand how the pieces fit together.

Lean on a professional

If this all sounds like too much, you can simply choose a fund that is already diversified based on your goals. Balanced funds offer a variety of investments. A target date fund adjusts your investments as you get closer to a specific date based on a goal — like college or retirement.

A financial professional can help you choose a mix of investments focused on your specific needs, which can help you get less distracted by the market’s ups and downs.