Why Is It Wise To Diversify?

You may be amused by the efforts of some of your friends and neighbors as they try to “chase the return” in the stock market. We all seem to know a day trader or two: someone constantly hunting for the next hot stock, endlessly refreshing browser windows for breaking news and tips from assorted gurus.

Is that the path to making money in stocks? Some people have made money that way, but others do not. Many people eventually tire of the stress involved, and come to regret the emotional decisions that a) invite financial losses, b) stifle the potential for long-term gains.

We all want a terrific ROI, but risk management matters just as much in investing, perhaps more. That is why diversification is so important. There are two great reasons to invest across a range of asset classes, even when some are clearly outperforming others.

#1: You have the potential to capture gains in different market climates. If you allocate your invested assets across the breadth of asset classes, you will at least have some percentage of your portfolio assigned to the market’s best-performing sectors on any given trading day. If your portfolio is too heavily weighted in one asset class, or in one stock, its return is riding too heavily on its performance.

So is diversification just a synonym for playing not to lose? No. It isn’t about timidity, but wisdom. While thoughtful diversification doesn’t let you “put it all on black” when shares in a particular sector or asset class soar, it guards against the associated risk of doing so. This leads directly to reason number two…

#2: You are in a position to suffer less financial pain if stocks tank. If you have a lot of money in growth stocks and aggressive growth funds (and some people do), what happens to your portfolio in a correction or a bear market? You’ve got a bunch of losers on your hands. Tax loss harvesting can ease the pain only so much.

Diversification gives your portfolio a kind of “buffer” against market volatility and drawdowns. Without it, your exposure to risk is magnified.

What impact can diversification have on your return? Let’s refer to the infamous “lost decade” for stocks, or more specifically, the performance of the S&P 500 during the 2000s. As a USA Today article notes, the S&P’s annual return was averaging only +1.4% between January 1, 2001 and Nov. 30, 2011. Yet an investor with a diversified portfolio featuring a 40% weighting in bonds would have realized a +5.7% average annual return during that stretch.

If a 5.7% annual gain doesn’t sound that hot, consider the alternatives. As T. Rowe Price vice president Stuart Ritter noted in the USA Today piece, an investor who bought the hottest stocks of 2007 would have lost more than 60% on his or her investment in the 2008 market crash. Investments that were merely indexed to the S&P 500 sank 37% in the same time frame.¹

Asset management styles can also influence portfolio performance. Passive asset management and active (or tactical) asset management both have their virtues. In the wake of the stock market collapse of late 2008, many investors lost faith in passive asset management, but it still has fans. Other investors see merit in a style that is more responsive to shifting conditions on Wall Street, one that fine-tunes asset allocations in light of current valuation and economic factors with an eye toward exploiting the parts of market that are really performing well. The downside to active portfolio management is the cost; it can prove more expensive for the investor than traditional portfolio management.

Believe the cliché: don’t put all your eggs in one basket. Wall Street is hardly uneventful and the behavior of the market sometimes leaves even seasoned analysts scratching their heads. We can’t predict how the market will perform; we can diversify to address the challenges presented by its ups and downs.