The importance of diversification

It is widely considered the cardinal rule of investing—diversification. The idea is closely associated with the idiom, “Don’t put all your eggs in one basket.”

When it comes to investing, investment experts agree that it’s important to diversify your portfolio—a strategy that helps mitigate losses in bear markets. After all, United States stock markets have experienced negative years 22 percent of the time, along with three bear markets with losses of about 50 percent, since 1970. [i]

When markets are on the upswing, it can be tempting to move most of your funds into equities. However, because investors’ crystal balls can get cloudy occasionally and markets can fall with little notice, it’s prudent to maintain a diversified portfolio. Diversification helps investors resist the urge to sell when markets are falling or to invest too heavily in one area when markets are rising.

By the time the typical investor reacts to a crashing stock market, the vast majority of the damage to their portfolio has been done. Investing is an art--and disciplined investing in a diversified portfolio produces better long-term results. 

Experienced money managers recommend their clients spread their money around and invest in stocks to grow their portfolios, bonds for steady income, real estate to act as a buffer when stocks drop, international investments for growth and cash for portfolio stability. Many investors utilize pooled investments with stock and bond funds, including mutual funds, exchange-traded funds, variable annuities and similar investments.  

The long-term value of diversification

Considering the last major market downturn during the Great Recession of the late 2000s and early 2010s, those who resisted the urge to sell and maintained diversified portfolios fared better in the long-term. In the 2008-09 bear market, many types of investments experienced losses. Yet, data shows that diversification helped contain portfolio losses.

The Fidelity Investments report “The pros' guide to diversification" profiled three hypothetical portfolios, including a diversified one with 70 percent stocks, 25 percent bonds and 5 percent short-term investments; a 100 percent stock portfolio and an all-cash portfolio. By February 2009, the diversified portfolio would have lost more than 35 percent of its value and the all-stock portfolio would have lost nearly 50 percent of its worth. The all-cash portfolio would have risen nearly 2 percent. However, five years after the market hit rock-bottom, the all-stock portfolio would have increased by 162 percent, the diversified portfolio by nearly 100 percent and the all-cash portfolio by less than 1 percent. Taking a look at the results from January 2008 through February 2014, the all-stock portfolio would have gone up nearly 32 percent and the diversified portfolio nearly 30 percent. [ii]  

This helps illustrate the value of diversification. During rising markets, diversification isn’t the strategy to maximize investor gains, but it will help them realize most of the market gains and provide less volatility than simply investing in stocks.

Tips for diversifying your portfolio

Financial experts say a well-diversified portfolio should have an investment horizon of at least three to five years in order to weather most economic storms. In order to build a diversified portfolio, several steps need to be taken.

Pick your investment mix

First, make sure that your investment mix (stocks, bonds and short-term investments) is in line with your financial situation, volatility comfort level and your ROI timeline. Typically, this involves choosing the percentage of stocks you’re comfortable with. For example, a conservative portfolio might contain 20 percent stocks, 30 percent short-term investments and 50 percent bonds while an aggressive growth portfolio may consist of 85 percent stocks and 15 percent bonds.

If you will need the money in just a few years or are anxious about losing the money, a more conservative allocation would make more sense. If retirement is still decades away, a more aggressive mix will help ensure a greater growth potential for your investment over the years.

Revisit your portfolio often

To stay on track, investors should revisit their portfolios periodically, and re-balance their investments to ensure the mix is consistent with their financial goals and strategies. It’s important to monitor the investment portfolio at least annually, or when your financial circumstances change.  

Use Dollar-Cost Averaging

It’s also judicious to add to your investments on a regular basis. One method is known as dollar-cost averaging, an approach that is used to smooth out the peaks and valleys of market volatility. With dollar-cost averaging, you invest your money on a regular basis info a portfolio of stocks, bonds and money market accounts.

Although buying and holding and using dollar-cost averaging in a diversified portfolio is considered a sound strategy, it’s important to track the performance of your investments, stay current with overall market conditions and keep up to the date with the news. For stock investors, it’s vital to keep up with what is happening with the companies they are invested in.

Check Out Fees and Commissions

Finally, it’s always a good idea to keep an eye on the various fees and commissions paid to buy and sell stocks, mutual funds and other investments. Some companies charge transactional fees, while others charge monthly fees. Be aware of what you are paying and the services offered for it.

Investing is Fun and Rewarding

By taking a disciplined approach, investors will find diversification, dollar-cost averaging and investing both rewarding and educational. After all, what’s more enjoyable than making the right choices, watching your nest egg grow and enjoying your retirement with financial peace of mind.

 

[i] http://www.forbes.com/sites/janetnovack/2015/02/05/5-big-mistakes-investors-make-when-they-diversify/#1c48243e2f43

[ii] https://www.fidelity.com/viewpoints/guide-to-diversification

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