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What Is Diversification In Investing?

An image explaining the four types of mutual funds to diversify your portfolio.

Key Takeaways

  • Diversification is simply about spreading your money across different types of investments to reduce risk—so you’re not putting all your eggs in one basket.
  • To diversify your portfolio, we recommend investing evenly across four types of growth stock mutual funds: growth and income, growth, aggressive growth, and international. This balanced approach helps you grow your money while protecting against losses.
  • To make the most of your diversified portfolio, prioritize investing with tax-advantaged retirement accounts first. By investing with a 401(k) and Roth IRA, you can take advantage of company matches and tax-free (or tax-deferred) growth.
  • An investment professional can help you set up your diversified portfolio, make adjustments as needed, and ensure your financial future is on track.

Diversification may sound like a sophisticated financial word that requires a PhD to understand. But if you pause and think about the first part of that word—diverse—all it really means is variety.

You could think of it like a buffet where you get to pick and choose what goes on your plate. Grab some veggies. Go for the steak. Add a baked potato or side salad. Go crazy and add a dessert, if you want. At the end of the line, you’ll have a lot of good stuff on your plate.

Diversifying your investments is a little like going through that buffet line—you’re simply adding different types of investments to your portfolio so you’re not all-in on just one opportunity.

But what does diversification look like in practice? And why is it important to have a diversified portfolio? Let’s take a look.  

What Is Diversification?

Diversification, one of the basic principles of investing, is the strategy of reducing risk by spreading out your money into different types of investments. Basically, it helps you sleep at night knowing your money’s not only safe but also has room to grow.

You’ve probably heard someone say it’s bad to put all your eggs in one basket. When you apply that idea to investing, it means you don’t bet your whole retirement on a single investment opportunity. Do that, and you could lose everything.

Since your financial journey is a marathon and not a sprint, diversification is an important part of successful investing for the long term. Instead of chasing quick gains on single stocks, you’ll want to take a balanced, low-stress approach and build wealth slowly.

Why Is Diversification Important?

The main reason you want to diversify your investments is to reduce risk (sorry—it’s not possible to eliminate it altogether). When you have a good mix of investments in your portfolio (aka diversification), you can put your money to work without worrying too much about your financial future. When you’re diversified, if one of your investments tanks, you can still be okay. Why? Because you have other investments to fall back on.

Let’s illustrate this point with a story.

Cody owns a business making custom T-shirts, and Meredith owns a business making custom hats. They move in the same circles, and both earn $100,000 per year in sales. But besides these similarities, their businesses are verydifferent.

Cody’s average sale is a few bucks, but he has a long list of clients. Meredith, meanwhile, scores a huge sale twice each year . . . but she only has one client. Question: What happens to Meredith if that one client goes belly-up? That’s right—her only source of income is gone. Poof!

money bag

Market chaos, inflation, your future—work with a pro to navigate this stuff.

It’s the same with your investment portfolio. If you put all your retirement savings into a single stock and that company goes under, your investments vanish along with the company. This is why we don’t recommend investing in single stocks—if someone hiccups on Wall Street (or in Washington), everything you’ve saved for retirement could be gone forever.

Types of Diversification

When finance experts talk about diversification, they usually mean holding different asset classes (or types of investments) in your portfolio. But diversification can also refer to the idea of spreading your investments out across different industries—or investing in companies based in other countries. Let’s take a deeper look at your options.

Diversification by Asset Class

If you diversify by asset class, you’re spreading your investments across a mixture of different types of investments. These are the most common asset classes:

  • Single stocks: These represent shares (or tiny pieces) of a single company. When you buy a company’s stock, you’re purchasing a small piece of ownership in that company.
  • Bonds: These are loans between an investor and a corporate or government borrower that promises to repay the money with interest.
  • Mutual funds: These are professionally managed investments where folks pool their money together to buy shares of a certain type of investment, like stocks and bonds.
  • Exchange-traded funds (ETFs): These are similar to mutual funds, but they can be bought and sold like stocks. Since they’re usually managed passively, they often have lower fees than mutual funds.
  • Index funds: These are also like mutual funds, but they’re designed to mirror the performance of a market index, such as the S&P 500. By investing in the same companies within that index, an index fund is locked to its ups and downs.
  • Real estate: For most people, the home they live in is their most valuable asset—and a huge chunk of their net worth. Others invest in real estate properties (such as commercial property or rentals) as another source of income.

Pro tip: If you’re a homeowner, you can already consider yourself somewhat diversified. Owning a home is a great way to build equity outside your traditional investment portfolio, and there are tons of great ways to invest in real estate

Diversification by Industry

Another way to diversify your investment portfolio is to make sure you hold investments in different industries and sectors of the economy.

For example, instead of only investing in stocks or mutual funds tied to companies in the tech sector, you might also want to invest in funds and stocks in the transportation, energy, health care and professional services industries too. That way, if one industry or sector of the economy suffers, only part of your portfolio would be affected (which is better than your entire portfolio feeling the sting).

Diversification by Location

If your portfolio is diversified by geographical location, that means you’re invested not just in local companies but also those in other regions and countries.

For example, to diversify by location, you’d invest not just in American companies but also those based in Japan, Europe and Australia, for a healthy international mix. This spreads your risk and potential reward across the global economy.

How to Diversify Your Investment Portfolio

Ramsey takes a simpler approach to diversification than a lot of so-called financial experts. Instead of focusing on complicated investments or looking for shortcuts (we’re looking at you, crypto), we recommend keeping it simple by investing in good growth stock mutual funds. That way, you can set it up and watch it grow with minimal stress.

Before we get to the how, we need to explain the why—so here’s why mutual funds are better than other common asset classes:

  • Unlike single stocks, mutual funds are already naturally diversified. They’re like buying the variety pack of your favorite candy—you get a mix of everything (dang it—now we want a snack).
  • Long-term government bonds generally yield somewhere around 4–5%.1 Good mutual funds, on the other hand, usually outperform those returns by a lot. In fact, the stock market has a historical average annual rate of return between 10–12%.2
  • Investments like index funds and most ETFs try to mirror what’s happening in the market. But if you pick the right mutual funds, there’s a good chance you can beat the index over time.

Let’s walk through the three steps you can take to diversify your mutual fund portfolio.

1. Make the most of tax-advantaged retirement accounts.

The best way to get started diversifying your investments is to make sure you’re prioritizing accounts that give you the most tax advantages (because who wants to pay more taxes?). Traditional retirement plans like a traditional 401(k) or 403(b) can help you save for retirement with tax-deferred growth, while Roth accounts like a Roth 401(k) or Roth IRA give you tax-free growth and tax-free withdrawals in retirement.

If you’re not sure where to start, just remember this rule: Match beats Roth beats traditional. For example, let’s say you have access to a traditional 401(k) that comes with an employer match:

  • Start with the 401(k) and invest up to the match (because that’s free money!).
  • Then you can open a Roth IRA and max out that account if you can (we love Roth accounts because we love tax-free growth and withdrawals in retirement).
  • And if you still have room in your budget to invest for retirement (once you’re debt-free, we recommend saving 15% of your gross income for retirement), then you can simply go back to your workplace plan and invest more there.

2. Diversify with different types of mutual funds.

Your investment accounts are kind of like grocery bags, so they’re meant to carry stuff. And now that your 401(k) and Roth IRA are set up, the real fun can begin! It’s time to go shopping for the “groceries” that will fill up those bags—the actual mutual funds where your money will grow until you reach retirement age.

Since we’re talking about diversification in investing, exactly what types of mutual funds should you spread those investments into? We’re glad you asked. We recommend investing evenly between four different types of growth stock mutual funds: growth and income, growth, aggressive growth, and international. That means if you have $1,000 to invest each month, for example, you’d put $250 (or 25%) into each of those types of mutual funds.

Now, as you explore your investment options, you might see a list of funds with impressive descriptions and names, like First Bank of Outrageous Growth Fund or Enormous International Fund (or similar). It can be a little tricky trying to figure out what’s what at this stage. But don’t worry—we’re going to explain what each fund type means right now.

Growth and Income Funds 

These funds bundle stocks from large, established companies like Apple, Home Depot and Walmart. They’re also called large-cap funds because the companies are valued at $10 billion or more (the cap stands for capitalization, which is just a fancy word for money or value).

The goal of investing here is to grow your money without too much risk. These funds are the most predictable of the four types and less prone to wild highs or lows.

Growth Funds 

These funds are made up of stocks from growing (or mid-cap) companies valued between $2 billion and $10 billion. They often earn more money than growth and income funds but less than aggressive growth funds.

Aggressive Growth Funds

These funds have the highest risk but also the highest possible financial reward (the fancy word for this is volatility). They’re the wild child of funds, also referred to as small-cap because they’re usually valued between $250 million and $2 billion. The companies in these funds are generally new, possibly even start-ups. These funds specialize in the kinds of companies that have high growth potential but could also swing wildly in value.

International Funds

These funds are made up of stocks from companies outside the U.S. If the market takes a dive here in the States, you might not see the same downturn in foreign countries, which is why you could benefit from investing in this type of mutual fund.

Diversifying your portfolio means spreading your money evenly across the above four kinds of mutual funds. When you’ve invested 25% of your portfolio in each of these four types and one type of fund isn’t doing well, the other three usually balance out potential losses. You never know which stocks will go up and which will go down, so diversifying your investments gives you the best protection.

3. Meet with your investment pro to make adjustments as needed.

The stock market can feel complex, with lots of variables. And your funds’ values will change over time as the value of the company stocks inside each fund rises and falls.

That’s why it’s so important to talk with an expert who knows how to help you in your situation. You should touch base with your investment pro from time to time—probably once or twice a year—to make sure your investments are still performing the way they should.

Not only can they help you make important decisions (like whether to change a fund based on its performance) they can also figure out if you need to rebalance your portfolio. Rebalancing is simply about making small adjustments to how you’re allocating money so you maintain that 25% diversification in each type of fund we just mentioned.

Remember, consistency is the key to successful investing. When you’re diversified, you can ride out the downturns in the market and stay focused for the long haul.

Work With an Investment Professional

Okay, we’ve covered the basics. But maybe you still have lots of questions about how to get started diversifying your portfolio. Questions are a good thing! Working with an investment professional like a SmartVestor Pro can make a huge difference as you figure this out.

So don’t go it alone—your financial future is too important to leave to guesswork. An investment professional can help you make sure your investments and assets are properly diversified to create a balanced plan for your retirement.

Next Steps

  • If you have a 401(k) or other workplace retirement plan, set up a meeting with your HR representative to talk through how you can diversify your retirement investments.
  • Check out the free tools and resources on the Ramsey Investing Hub—like the Retirement Assessment and Investment Calculator—so you can start investing for retirement with confidence.
  • Have questions about diversifying your portfolio? With the SmartVestor program, you can get in touch with an investment professional who can walk you through your options and help you create a custom plan for your retirement.

Make an Investment Plan With a Pro

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Find Your Pros

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros. 

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About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.