They say that variety is the spice of life, but it also serves a practical purpose. For instance, you wouldn’t construct a sports team with players who are all the same type. You want them to have different skills that complement each other and help build a strong overall team.

The same principle applies to investing. Holding a portfolio of different securities is one of the keys to long-term investment success. It’s called “diversification” and this proven technique can be effective in improving a portfolio’s risk-return profile (i.e., it’s designed to enhance performance over the long run while helping to mitigate risk).

How diversification works

Another common saying is, “don’t put all your eggs in one basket.” If something bad happens to the basket, you could lose all your eggs! That’s the crux of diversification. Imagine you have $50,000 to invest and you put it all into one stock. If the stock performs well, you’ll make big profits. But if it struggles, you could lose a lot of money. Through diversification, you might choose to invest $20,000 in that stock, for example, and then allocate the remaining $30,000 across three or four others. This way, you’re spreading the risk and not pinning all your hopes on one particular company.

When you own different stocks, you may better withstand a downturn in one holding because other holdings could be thriving. Of course, if markets crash then most stocks may decline in value, but diversification gives you a fighting chance of staying afloat.

Ways to diversify

You can apply a diversification strategy at different levels. A basic approach is to diversify by asset class (e.g., investing some money in stocks and some in bonds). Oftentimes, the stock market may perform well when the bond market doesn’t, and vice versa. Investing in both asset classes can provide your portfolio with better balance and reduce volatility (i.e., diversification may “smooth out” performance to help avoid a stressful roller coaster of extreme returns).

Even within asset classes, you can diversify. Instead of buying only bank stocks, for example, you’d also invest in health care companies, the oil & gas industry, the information technology sector and more. Some companies might be bigger and more established, while others might be smaller and more growth oriented. As well, you could buy bonds of companies from different market segments or with different ratings or maturity dates. Going a step further, you might also invest across various regions of the world to gain geographical diversification and perhaps valuable exposure to different currencies, too.

Points to consider

Although diversification offers many benefits to investors, you can have too much of a good thing. Over-diversifying may “water down” your portfolio and limit your upside potential. You want to diversify effectively while still having “conviction” in a focused group of investments that you (and your advisor if you have one) believe will perform well on a relative basis over the long term.

Also, you might start out by diversifying your portfolio with certain weightings that make sense for your circumstances. For instance, you could begin with 60% of your assets held in stocks and 40% in bonds, to strike a reasonable balance between growth potential and steady income. As time goes by, maybe stocks have outperformed and now represent 72% of your portfolio, leaving only 28% in bonds. That allocation might expose you to too much risk since stocks are generally riskier than bonds, so be sure to periodically rebalance your portfolio to the various weightings you desire.

An Alterna Advisor can help you diversify effectively and rebalance when needed. You may also wish to invest in professionally managed portfolios like mutual funds or exchange-traded funds that conveniently feature built-in diversification and regular rebalancing.