From the outset, it is important to be mindful of what constitutes diversification and what does not. Owning a lot of stocks and bonds might make you think you are diversified, but if they all act the same way, you are not really diversified. Owning an S&P 500 index fund, for example, gives you exposure to 500 different stocks, but it does not address the risk that the entire stock market might underperform.
There is a big difference between having a diversified stock portfolio and a diversified investment portfolio. To achieve meaningful diversification, you need to have several different kinds of investments.
Typically, a diversified portfolio will include a mixture of various investments that do not correlate with each other – in the broadest terms, that means when the value of one goes up, the value of the other tends to go down.
A well-diversified portfolio might include securities representing:
- U.S. stocks of different sized companies
- U.S. fixed income including Treasuries and corporate bonds
- Foreign stocks from both developed and emerging markets
- Foreign fixed income, including both corporate and government issues, and
- Commodities, which includes natural resources like gold, oil, and real estate.
As an investor, you will want to use asset allocation to determine the best mix of these various asset classes. And just what is the right mix? Unsurprisingly, the answer is- it depends.
Your asset mix will depend on your comfort with different risk levels, your goals, and where you are in life. For example, if you need the money in the next few years, you should hold more bonds than someone who could wait 10 years. Everyone’s situation is unique.