Stocks have been up lately and many may be tempted to “dive in” and move everything to stocks. But is chasing returns the way to go? We all want the highest possible returns, but risk management matters just as much in investing. That is why diversification is so important. I have always favored a globally diversified portfolio. 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 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.1
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, but we can diversify to address the challenges presented by its ups and downs. Keep in mind that while diversification may help reduce volatility and risk, it does not guarantee future performance. Diversifying across a range of asset classes certainly will help mitigate risk, but it does not eliminate risk. No investment strategy can eliminate the risk of fluctuating prices and uncertain returns.
1. usatoday.com/money, Investment Diversification, 12-8-11
Damien helps individuals invest and manage risk. He is a Certified Financial Planner™ professional and a principal of Walnut Creek Wealth Management. These are the views of Damien Couture, CFP® and not intended as investment advice. Investors cannot invest directly in an index. Your comments are welcome. Damien can be reached at 925-280-1800 x101 or Damien@WalnutCreekWealth.com.