How to diversify your investment portfolio

You’ve probably heard the advice, “Don’t put all your eggs in one basket.” When it comes to investing, that’s called diversification. A diverse portfolio spreads your money across different investments. Losses in one area might be balanced out by gains in another area. 

In this guide, you’ll learn how to diversify your portfolio investments so you can create a well-rounded mix that fits your goals.

• What is a diversified investment portfolio?
• Investing terms to know for portfolio diversification
• How to diversify your investments in 3 simple steps
• Things to look out for when diversifying your portfolio

What is a diversified investment portfolio?

A diversified portfolio holds a variety of investments instead of putting money in any one industry, company or region. Different types of investments tend to react differently to the same market conditions. When some are down, others may hold steady or go up. Maintaining balance in your portfolio helps protect your money over time.

Here’s an example of how portfolio diversification works: If you’re mostly invested in technology stocks and that sector has a bad year, your whole portfolio would be affected. If you hold bonds, real estate and cash savings alongside those tech stocks, your overall portfolio likely won’t take as much of a hit. That’s because you’d be less exposed to market volatility.

Asset allocation explained

Asset allocation is how you decide to divide your money among different investment categories. Each asset class like stocks, bonds and cash equivalents has its own risk profile and performance trends and may respond differently to factors like interest rates. Diversifying your investments across companies, industries and sectors can help lower your risk and increase the likelihood of earning returns. Diversification alone does not ensure you’ll earn a profit nor guarantee against investment loss during a market downturn.

One well-known example of asset allocation is the 60/40 portfolio. This involves putting 60% of your portfolio in stocks and 40% in lower-risk investments. A 60/40 portfolio allocation is often used by investors who want to balance growth with a moderate level of investing risk. 

Here’s an example of what that might look like in practice:

Age plays a role in asset allocation, too. The more time you have before you’ll need the money, the more risk you can afford to take on. Some investors use simple rules of thumb when deciding their best investment strategy based on age. One example is to subtract your age from 110 to estimate how much of your portfolio to invest in stocks. For example, a 40-year-old might choose to invest around 70% of their portfolio in stocks (110-40=70). Someone closer to retirement might choose to invest in fewer stocks (110-60=50). 

Investing terms to know for portfolio diversification

Before you start diversifying your portfolio, it helps to get comfortable with a few key investing terms. Knowing them will make the rest of this guide—and your investing journey—a lot easier.

• Risk is the possibility that an investment will lose value or won’t perform as expected. 
• Stocks are shares of ownership in a publicly traded company.
• Bonds are a type of fixed-income investment and a way for governments and companies to borrow money from investors.
• Mutual funds pool money from many investors to buy a mix of securities and are typically bought and sold through a fund provider at the end of the trading day.
• Exchange-traded funds (ETFs) are similar to mutual funds but trade on an exchange.
• Index funds are a type of fund that tracks a specific market index, like the S&P 500.
• Share certificates and certificates of deposit (CDs) are savings vehicles that offer a fixed-rate of return over time. 

How to diversify your investments in 3 simple steps

You can build a diversified portfolio by focusing on a few key decisions. Break the process into these 3 steps to make it easier to take action:

1. Determine your goals, timeline and risk comfort

Get clear on your investment objectives before you choose any investments in your portfolio. The answers to these 3 questions will shape every investing decision you make:

• What am I investing for?
• How long do I have to get there?
• How much risk am I comfortable taking on? 

Start with your investing timeline. Younger investors with at least 30 years ahead of them typically can afford to take on more risk. That’s because market dips are easier to absorb when there’s plenty of time to recover. Some investors choose target-date funds. They can automatically adjust their investment mix over time based on a planned retirement year. Investors who are closer to retirement usually want to protect the profits they’ve built. To do that, they’ll shift their portfolio investments to more stable, lower-risk holdings.

Here’s an example of how different people might diversify their investments based on their age:

How much risk you can afford to take is called risk capacity. How much investing risk you’re comfortable with is called risk tolerance. It’s important to understand the difference and evaluate how you feel about investing risk. Some people are comfortable watching their portfolio fluctuate in exchange for the chance at higher returns. Others prefer steadier, more predictable growth even if that means lower returns. 

There’s no one right approach. Knowing your tolerance for investment risk can help you build a portfolio you’ll stick with.

2. Find the right mix of asset classes

Spreading your money across your portfolio involves choosing investments that serve different purposes. That can provide growth potential, balanced stability and a safety net for your portfolio through market swings.

Think of mixing assets like filling up 3 distinct buckets in your portfolio:

Within each bucket, there’s more room to diversify. Some investors also consider alternative investments—like real estate or commodities—to further diversify their portfolio. For example, stock investors might spread investments across different sectors, company sizes or regions. This additional diversification helps ensure you’re not overly dependent on one slice of the stock market.

Mutual funds and ETFs are often used to help diversify a portfolio because they hold many investments. Looking at each fund’s general focus—like whether it tracks a broad market or a specific sector—can help you understand how diversified your overall portfolio mix is.

On the other hand, a portfolio can be too diversified. Spreading money across too many investments may not reduce much investing risk. Smart investing means taking time to evaluate your investments to ensure you have a well-balanced portfolio.

3. Monitor your portfolio’s performance

Building a diversified portfolio isn’t a one-time task. Different investments grow at different rates, so your original allocations will drift naturally. An investment mix that started at 60% stocks and 40% bonds might shift closer to 70/30 during a strong stock market. That can leave you with more investing risk than you had intended.

Rebalancing your portfolio means checking in on your allocations and making any necessary adjustments to return your portfolio to your desired investment mix. This helps you make sure your portfolio continues to reflect your wealth-building goals.

For most investors, rebalancing once a year is a good idea. If you experience any major life changes like a new job, marriage or retirement, consider reviewing your portfolio sooner than scheduled.

Think about these questions during your annual portfolio review:

• Is my current asset allocation still in line with my goals and risk tolerance?
• Has any single investment or sector grown large enough in my portfolio to change my desired balance?
• Has my financial situation changed in a way that calls for a different investing approach?

Rebalancing might mean selling an investment that has grown beyond your target and reinvesting in areas that have lagged. Or, it might mean directing new contributions toward underweighted areas. The goal is to be intentional about your portfolio mix rather than letting the market decide for you.

Things to look out for when diversifying your portfolio

Even a well-planned portfolio can drift off course if a few important factors aren’t addressed. Here are a few things worth keeping an eye on as you build and maintain your portfolio over the long term:

Don’t spread your investments too thin

There’s a point where more holdings add complexity instead of protection. Keeping tabs on your money can be challenging if it’s scattered across too many investments. And, you could end up paying more money in transaction fees when it’s time to rebalance each year.

Stay informed about what’s happening in the economy

Consumer habits, industry trends and the economy all affect how different investments perform. Check out Navy Federal Credit Union’s monthly Market Insights report to see what’s driving today’s markets and how that could affect your portfolio and investment decisions.

Be attentive to current events

Major world events like wars, natural disasters and supply-chain disruptions all can affect the markets. Being aware of what’s happening can help you understand what your investments are doing and whether any adjustments make sense.

Keep tabs on changes in technology

Technology tends to move fast, and its effects on different industries can be dramatic. New industries can emerge, while established companies and sectors may face serious disruption. Staying aware of tech trends can help you avoid being overexposed in a market downturn.

Watch out for fund overlap

If you invest in multiple mutual funds or ETFs, it’s worth checking what’s inside each one. For example, many popular ETFs and mutual funds are concentrated in the same large-cap technology stocks. Review the top 10 or 20 holdings in each of your funds now and then to look for concentrated investments. Then you can rebalance your portfolio before the lack of diversification becomes an issue.

Navy Federal can help you build a diversified portfolio

Once you understand how to diversify your portfolio, you can put what you’ve learned into practice. Navy Federal offers tools and support to help you invest with confidence. You can get hands-on guidance from a Navy Federal Investment Services advisor. Or, take a digital, self-directed approach with our Digital Investor tool. Keep learning at your own pace with our MakingCents library of investing resources.