Does Diversification Still Work?
Hindsight may be 20/20, but investing is about looking forward.
When looking at the performance of their portfolios, many investors can’t help but wonder "If only" – "If only I had greater exposure here" or "If only I allocated more of my portfolio to a different asset class." With this mindset, you may be tempted to think the only thing diversification accomplishes is offsetting your best investments with your worst ones. Investing, though, is about looking ahead – making thoughtful decisions in the face of an unknowable future. From that perspective, diversification could be critical to building a smart portfolio in an unpredictable market.
What is Diversification?
Diversification is a basic portfolio strategy where you invest in a mix of unrelated asset classes – so when some investments zig, others will zag. Instead of putting all your investment eggs into one basket and hoping for the best, you’re distributing them in several independent baskets. By doing so, you may be able to capture a good portion of broad market increases while mitigating declines specific to one sector or asset class.
Do You Feel Lucky?
Over the last 20 years, there have been only two instances when an asset class was the top performer in consecutive years – large-cap growth stocks in 1998–1999 and taxable bonds in 2000–2001. The rest of the time, investors who went all-in on the previous year’s top asset class missed out on the current year’s top performer, ultimately underperforming their expectations. Instead of trying to predict which investments will perform the best – and getting the timing just right to capitalize on it – a diversified portfolio can make it easier to participate in broad market gains and produce more stable returns.
Protection When Markets Go South
The potential for softening the blow of a down market can be especially powerful in a steep decline, like we saw in 2008–2009. While a diversified portfolio may still suffer losses in such a market, those losses tend to be less severe when compared to an undiversified one. Consequently, it would be better positioned to rebound because it lost less value in the downturn.
Focus On The Big Picture
Diversification also helps investors avoid making knee-jerk reactions to the market. It is incredibly difficult to predict what sector or asset class will shine the brightest – and with their own money on the line, investors will frequently chase yesterday’s best-performing sectors and shun poor-performing ones. A well-diversified portfolio makes it easier to “buy low and sell high,” tolerate slow performers and keep the bigger picture in mind.