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Why Diversification Is Important When Investing

Key Takeaways

  • Diversification can help reduce the risk that you don’t meet your future financial goals.
  • Consider spreading your net worth across multiple asset classes that work in different directions.
  • Don’t get drawn into the “chasing returns” mentality.

“Don’t put all your eggs in one basket.”

It’s a common expression, but did you know it’s also valuable advice when investing? Diversification — a common strategy when building a portfolio — involves investing in a variety of assets rather than one particular asset class.

“Diversification is very important to reduce portfolio risk, and reduce the risk that you might not be able to meet your future goals,” says Mike Cornacchioli, Senior Strategy Analyst, Citizens Bank Private Wealth Management.

How diversification reduces risk

Putting your entire net worth into one stock or asset class is a risky endeavor. If the stock or asset class does not perform, it can do tremendous damage to your portfolio. By diversifying your portfolio, you spread your net worth across multiple asset classes that work in different directions, thus limiting the fluctuations in your performance.

For example, stocks tend to be negatively correlated with bonds. In the event of a stock market correction, your bonds should provide balance to your portfolio and potentially offset any losses.

“When you pair assets that have negative correlations,” Cornacchioli says, “that tends to be beneficial and lowers the risk.”

Why it’s important to diversify investments

Some investors get into trouble when they outweigh their portfolio to a top performing asset class; this is the classic “chasing returns” mentality. However, it’s important not to get drawn into this tactic because, as Cornacchioli explains, “last year’s winners are often next year’s losers.” One year, international stocks could be the top performing asset, but could be the worst performing asset the next year.

Diversifying can put you in better position to withstand dips in performance and therefore stay the course as you work towards reaching your financial goals. That way if your portfolio is skewed heavily to one asset and they happen to perform poorly, you’re not forced to sell low and accept major losses.

The bottom line

Proper asset allocation is seen as critical to becoming a successful investor. That’s why diversifying your portfolio can be so important: It helps offset poorly performing assets so you’re not forced to sell low and experience damaging losses that impact your financial goals. Instead, diversification allows you to better absorb reasonable dips in performance and stay the course with your investments so you have a better opportunity to reach your goals over the course of your investment horizon.

Remember: Diversification does not ensure a profit or guarantee against a loss.

More information

Investing can be a helpful method of planning for the future, whether it’s your retirement or any other financial goal. To learn how we can help you invest for the future, visit us online or schedule a Citizens Retirement Checkup at your nearest Citizens Bank branch.

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