Why Should I Diversify My Portfolio?
In the previous blog post “Should I Time the Market?” there is a table that shows the annual investment returns for different asset classes. The point of that blog was to demonstrate that timing the market is difficult to do and can diminish investment returns because of the opportunity cost of waiting for the “perfect” time to invest. If you read the table closely and try to follow a single asset class for each year, then you’ll notice that in some years it performs well (relative to other investments) and performs poorly without any discernible pattern.
This is one of the strongest reasons for diversification - because nobody knows what future returns will be for any asset class.
We are familiar with the saying, “Don’t put all your eggs in one basket,” and it is applicable to investing. When we recommend diversifying an investment portfolio, we typically mean two things. First, it means investing in different asset classes. Second, it means investing in different assets within those asset classes.
Investing in Different Asset Classes
You may find content online, usually on forums or social media, giving advice for how to invest your portfolio. If that content is targeted toward new investors, it is common that the information says to keep things simple and just invest in an S&P 500 index fund. This index fund consists of approximately 500 of the largest companies in the United States.
Historically, the S&P 500 has had relatively good investment returns compared to other asset classes. But, what does the future hold for the S&P 500? What if these companies perform poorly for any variety of reasons - lack of innovation, political instability, war, inflation? There are many different potential causes for poor performance that can’t be predicted. Putting all “eggs” in the S&P 500 “basket” may expose investors to risks unique to those companies in the United States. This type of risk is a key term called unsystematic risk. Thankfully, unsystematic risk is well-researched and it is possible to reduce it.
Investors do not need to limit themselves to only large companies in the United States. There is a very long list of asset classes that can reduce the unsystematic risk of a portfolio, but the essence of the solution is diversification. Investing in other asset classes whose returns are not correlated with the S&P 500 index (or whatever the index is) can reduce unsystematic risk. Common asset classes are small-cap stocks, foreign stocks, treasury bonds, corporate bonds, real estate, and commodities, but this is not an exhaustive list.
The focus so far has been to hedge against the downside risk of investing in just one asset class so you may ask, “But, what if the S&P 500 index continues to perform better than other asset classes in the future?” Keep in mind that diversification means lowering unsystematic risk by adding other asset classes, not forsaking one asset class entirely for another. Keeping a diverse mix of assets is a wise way to build a portfolio for the long-term.
Investing in Different Assets Within Asset Classes
New investors may be tempted to ignore advice concerning diversification and choose to buy individual assets. One misconception investors hold is that they have meaningful diversification in a certain asset class (like large-cap domestic stocks) because they invest in well-known companies that fit that category (like Google, Apple, Costco, or NVIDIA). Although these companies may seem stable, the reality is that individual stocks can be very volatile.
Back in January 2025, NVIDIA was a darling company because of its dominance in graphics cards and AI technology. It was a profitable company with strong leadership and a bright future with the advent of AI’s proliferation. However, a report came out at the end of January 2025 that a Chinese company created and trained its own AI model with a fraction of the processing power needed from the types of cards that NVIDIA sells. Investors saw this as a risk to NVIDIA’s business and the stock lost almost 17% in a single trading day. This is equivalent to more than $500 billion in market capitalization and the largest single-day loss for NVIDIA. That same day Wal-Mart had a modest gain in its stock price, unrelated to the news about NVIDIA.
These types of developments - positive and negative - are happening to individual companies all the time and the news will cause swings in the stock prices. These swings can be dramatic when investors hold only a very small set of companies. The previous example isn’t to suggest that investors should have owned Wal-Mart instead of NVIDIA. A portfolio invested in many companies of various sizes and industries can help to “smooth” out this volatility because their businesses are generally unrelated. Like the previous example, when one company’s stock is down another one’s may be up for completely unrelated reasons. Add in more companies and the consequence is to increase the overall diversification of the portfolio. In the US stock market, there are more than 4,000 publicly-traded companies!
What Can You Do?
Determining the appropriate investment allocation is going to depend entirely on an investor’s goals, aspirations, risk tolerance, time horizon, and ability to take investment risks. There is not a one-size-fits all solution for an investment allocation because everyone’s circumstances are different. Reflecting on one’s risk tolerance and time horizon can help come up with a general investment strategy. Consider asking yourself these questions as you review your investment allocation.
How would I feel if my portfolio lost value?
Do I have time to wait for my investments to recover?
Would I sell my investments if they lost value in a short amount of time?
For what goal/purpose am I investing these funds (college, down payment, retirement, etc.)?
Would I be more comfortable with a less volatile investment strategy?
How have I reacted in the past to market volatility? Did I sell or hold?
These questions are a starting point as you develop your overall strategy.
The opinions expressed in any commentary posted on this site are solely those of the individual author and do not necessarily reflect the views or opinions of Redspire Wealth Management, LLC. These opinions are based on information available at the time of posting and are subject to change without notice. Redspire Wealth Management, LLC does not commit to updating any posted positions or commentary to reflect subsequent developments. While the information and reasoning used to form these opinions are believed to be from reliable sources, Redspire Wealth Management, LLC does not verify this information, and no guarantee is provided regarding its accuracy, completeness, or validity. Redspire Wealth Management, LLC disclaims any and all liability for actions taken or not taken based on the content of this site. No warranty, express or implied, is given in connection with the content provided.