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Investing

Every financial planner will tell you to diversify your portfolio — here's what that means

Investors who diversify their portfolios are effectively spreading out their risk.

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You've likely heard the adage, "Don't put all your eggs in one basket." While this can be applied to many different facets of life, investing experts will often use the saying when explaining the importance of diversifying your portfolio.

Diversification is essentially a strategy of spreading out your investments across different asset classes. These asset classes can range from stocks and bonds to other investment categories like real estate. The idea is that you don't want to put all your money into just one investment, like dumping all your cash into large-cap value stocks or choosing only government bonds.

How you diversify your portfolio can have a big impact on your returns: When done correctly, diversification can minimize volatility while maximizing return opportunity, explains Shon Anderson, a Dayton, OH-based CFP and chief wealth strategist at Anderson Financial Strategies.

"Each asset class performs differently in various economic and financial environments," Anderson says. "So, when you have multiple asset classes, you should have more opportunities to have pieces of your portfolio make money in almost any environment."

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Think of diversification like a fruit stand

To understand why diversification is a good investment strategy, Greg DePalma, a Denver-based CFP and director of advisory services at Personal Capital, likes to forgo the egg basket adage for one about a fruit stand. Holistic portfolio management looks a lot like running a successful fruit stand, he argues.

Most would agree that, as a fruit stand owner, it's prudent to sell a variety of fruits instead of just one. "If a hurricane wipes out the orange groves in Florida, it would be helpful if you also sold apples from the Northeast or bananas from Hawaii," DePalma explains.

Managing your portfolio holistically means taking into account how one asset can offset the other. Anderson points out how we recently saw this with different types of stocks. Large-cap growth stocks and large-cap value stocks sound like similar asset classes but they performed very differently from one another when the market was doing well at the end of 2020 and again in 2021. Growth stocks outperformed value stocks by a huge margin in 2020, while value stocks outperformed growth stocks this year. Investing in both meant that any losses in one asset were offset by the gains in the other.

How to diversify your own portfolio

These days, it's quite easy to have a diverse portfolio. If you are on your own and don't have access to sophisticated tools used by professional money managers, Anderson recommends using a robo-advisor or target-date index funds, where your investments change as you approach your target retirement date.

Many robo-advisors will use a popular strategy called modern portfolio theory, or MPT, that follows funds like the S&P 500 and prioritizes diversification to minimize risk. Robo-advisors rely on low-cost mutual funds or exchange-traded funds (ETFs) that spread your investments across different assets.

One of the easiest ways for investors to diversify is by investing in a large number of companies through pooled investments like mutual funds and ETFs, or by purchasing a sufficiently large number of individual securities, DePalma explains. "Investors [should] attempt to diversify away from any risk involved with a specific company or investment," he says.

Whatever route you choose — doing it yourself through a broker or having a robo-advisor choose funds for you — make sure that your portfolio is built to consider your specific risk tolerance.

"The goals of different investors are usually not the same," DePalma says. "A young couple with no children, for instance, may want to try to maximize their returns with the understanding that the [investments] may be more volatile, while a retired couple might desire steadier returns to take their family on vacation every few years."

Robo-advisors are an effective way to invest with your risk tolerance being taken into consideration. Select reviewed 22 different robo-advisor platforms, and our top five picks have you fill out a brief questionnaire about your goals and risk, then they customize a portfolio based your answers. The below each offer low-cost diversification and will automatically adjust your investments regularly (also known as rebalancing):

You can read our methodology below for more information on how we chose the best robo-advisors.

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Our methodology

To determine which robo-advisors offer the best services for investors, Select reviewed 22 different platforms. We then narrowed down our top picks by considering the following factors:

  • Account minimums
  • Account, advisory, trading and fund fees
  • Investment vehicles offered
  • Selection of investments
  • Educational tools and resources
  • Customer support
  • Sign-up bonuses

After reviewing the above features, we based our recommendations on platforms offering the lowest fees, the widest range of investment options, usability and any unique features like access to a human advisor. We also looked into each company's customer support structure and app reviews.

Your investment earnings through a robo-advisor are subject to fluctuations of the market. Your earnings also depends on any associated fees and the contributions you make to your account. There are no guarantees you'll earn a certain rate of return or current investment options will always be available. To determine the best approach for your specific investment goals, speaking with a reputable fiduciary investment advisor is recommended.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.
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