With the swings we’ve seen in the stock markets lately, investing can feel like a risky venture. We all want to reduce risk in our lives, but many people don't think about diversifying their portfolios and how it relates to risk reduction. Some people may think that they are diversified, but in reality they hold a basket of similar stocks or bonds that all react in the same way to market events.
So, what is proper diversification, and how does it reduce risk? This article will discuss what a diversified portfolio should look like and how it reduces risk to help you reach your financial goals.
What Is Portfolio Diversification?
The concept is simple enough, yet many people fail to diversify their portfolios properly. Some people may receive stock options at work, and others may have a high conviction in a particular company. Still, the result creates an overly concentrated portfolio exposed to a high degree of risk entirely based on one or a few companies. Failure to properly diversify can cause many portfolios to have a much higher risk than an investor is comfortable with or even aware of.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
For an investor to truly have a diverse investment collection, they need to invest in several different asset classes and sectors that will react differently to market events.
- Asset classes include cash, stocks, bonds, real estate, etc. Those asset classes can get broken down further into specific sectors within those groups.
- Sectors within the bond category, for example, include government bonds, corporate bonds, high-yield, etc.
- Different sectors for stocks include technology, health care, financials, etc.
These asset classes and sectors will have moments when they are performing better than other categories, but no asset class or sector remains at the top forever. By spreading out your risks, market anomalies will have less of an impact on your portfolio. Think of it as betting on multiple horses in the race rather than just one.
Just because a portfolio is diversified doesn't mean it is guaranteed to go up in value. Some events will impact the broad financial market. For instance, during the 2008 financial crisis, only bonds and cash had positive returns for the year. Large-cap growth stocks fell by more than 38% in that year, and international stocks lost more than 41%. A well-diversified portfolio would've had negative returns in that year between 20% to 30%, but it still would've had better returns than the worst-performing categories of the market.
What Are the Benefits of Portfolio Diversification?
A diversified portfolio will likely have a better risk-adjusted return over a long period. While the diversified portfolio will never have returns as high as the top-performing sector, it will also never be at the bottom. A diversified portfolio will achieve the average returns of all the sectors invested with lower volatility along the way.
For example, in 2020, due to a decline in oil and gas consumption, energy companies lost 33%, making that sector the worst-performer in the S&P 500. All the while, the broader index rose over 16% for the year. However, as the COVID 19 lockdowns came to an end, energy consumption returned strong, causing energy to be the highest performer of 2021, with a 54% return. A broadly diversified portfolio across the S&P 500 would've seen an 18% gain in 2020 and a 29% gain in 2021, resulting in more than 52% return over two years. An investor solely concentrated in the energy sector would only be up 2% after recouping from their losses in year one.
Another example that spans an entire decade would be the 1970s. This decade experienced stagflation due to high unemployment, high inflation and low economic growth. The Dow Jones Industrial Average began the decade at 800 and closed it out at 839 points. Bonds had a negative real return after inflation. However, real assets like commodities and real estate did well due to higher-than-average inflation. Gold had a 10x return, while silver had a 15x return over the decade. REITs generated an annual return of 16.3%. Someone broadly diversified across multiple asset classes would've seen a better return than someone solely invested in stocks and bonds.
In Conclusion
Diversification is an essential element to minimize the risk of investing. Allocating investments across different asset classes and sectors can help stabilize your returns because no single sector or class will have as much impact on the overall performance of the entire basket.
Over time, even if some assets perform poorly, others should offset them so that you don't see too significant an effect on your overall performance.
-
Two Don'ts and Four Dos During Trump's Trade WarThe financial rules have changed now that tariffs have disrupted the markets and created economic uncertainty. What can you do? (And what shouldn't you do?)
-
I'm Single, With No Kids: Why Do I Need an Estate Plan?Unless you have a plan in place, guess who might be making all the decisions about your prized possessions, or even your health care: a court.
-
Two Don'ts and Four Dos During Trump's Trade War
The financial rules have changed now that tariffs have disrupted the markets and created economic uncertainty. What can you do? (And what shouldn't you do?)
-
I'm Single, With No Kids: Why Do I Need an Estate Plan?
Unless you have a plan in place, guess who might be making all the decisions about your prized possessions, or even your health care: a court.
-
Most Investors Aren't as Diversified as They Think: Are You?You could be facing a surprisingly dangerous amount of concentration risk without realizing it. Fixing that problem starts with knowing exactly what you own.
-
Will My Children Inherit Too Much?If you worry about how your children will handle an inheritance, you're not alone. Luckily, you have options — from lifetime gifting to trusts — that can help.
-
Charitable Giving Lessons From Netflix's 'Apple Cider Vinegar'Charity fraud is rife, and a Netflix series provides a timely warning about donating money to a good cause without looking into its background.
-
Four Takeaways From Filing Your Taxes to Boost Your Financial FutureNow that another tax season is in the rearview mirror for most of us, what lessons can you take from what you learned about your finances to plan for the future?
-
What Claims Adjusters Are Thinking vs What They're SayingAfter a natural disaster, few of us are at our best, but here's what to keep in mind when you're interacting with your insurance company's claims adjuster.
-
Looking to Make a Job Change? How to Stand Out Like a ProTo make a strong first impression in interviews or when networking, skip your job title and work history and use an opening gambit that highlights your talents.
