Here's How Much Diversification You Actually Need -- and Why Falling Short Is So Risky

If your parents or grandparents ever warned you against putting all your eggs in one basket, you've already learned the basics of diversification. As simple as the concept seems, failure to stay on top of diversification can sink your financial plan. Here's how.

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How much diversification you need

Diversification doesn't simply mean owning many assets. It means owning things that don't all rise or fall at the same time. If all your investments move together, you're not actually diversified, no matter how many assets you own. But here's the good news: You don't need hundreds of shares to create a diversified portfolio. Research finds that you can minimize most risk once you hold a few dozen well-spread shares.

What's well-spread?

True diversification involves spreading money across:

• Different companies and sectors (like healthcare, consumer discretionary, and tech).
• Different asset classes (such as stocks, bonds, cash, and real estate or gold).
• Different regions (your home market plus international).

Diversification allows you to avoid relying on the success of a single company or sector because you've covered your bases by investing in other companies and sectors.

One of the easiest ways to diversify

Investing in an exchange-traded fund (ETF) is one of the simplest ways to gain instant diversification. For example, the Vanguard Morningstar Total Stock Market ETF (NYSEMKT: VTI) includes almost the entire U.S. stock market in a single fund -- and with an extremely low expense ratio of 0.03%. VTI tracks the whole U.S. market, offering instant diversification.

If you also want worldwide diversification, iShares MSCI ACWI ETF (NASDAQ: ACWI) spreads money across thousands of stocks from many countries and sectors. World ETFs are useful as a one-stop way to own global stocks in a single, diversified fund.

The tricky bit

A portfolio is only diversified if you don't have overlap. For example, if you have two ETFs tracking the S&P 500, the top holdings for each may be similar, if not the same. That just means you hold more of a particular asset. If you decide to invest in ETFs, take the time to identify how much overlap there is.

The important thing to remember is that you don't want all your assets to move in the same direction when something big strikes, like a geopolitical crisis, recession, sudden industry shift, or inflation.

Why falling short is risky

Let's say inflation soars, squeezing company profits and forcing central banks to raise rates. If that were to happen, bond prices would fall, highly indebted companies would likely struggle, and some stock sectors -- like high-growth tech -- could drop sharply. If you're concentrated in any of these areas, what you once believed to be a diversified portfolio is likely to be hit hard.

However, if your portfolio also holds assets known to hold up better during inflationary periods -- such as certain commodities, inflation-proof stocks, or inflation-linked bonds -- your portfolio stands a much better chance of weathering the storm.

Lack of diversification can damage your overall financial picture, but fortunately, it's an easy problem to fix.

Dana George has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.