What is Diversification?
Diversification is simply another way of saying, “spread out your risk” or “don’t put all your eggs in one basket.” Diversifying your investments helps them to weather volatility and may also improve returns based upon your level of risk.
Diversified portfolios contain a mix of equities and sometimes bonds, but at the core of every great diversified portfolio are investments that react very differently to the same economic environment. Sometimes referred to as uncorrelated investments, a diversified portfolio includes a mix of assets that zig while others zag.
Though the ultimate goal of diversification is not necessarily to boost performance—it won’t ensure gains or guarantee against losses— once you target a level of risk based on your goals, time horizon, and tolerance for volatility, diversification has the potential to improve returns within that level of risk.
The Effect of Diversification in 2008-2009
In the eyes of seasoned investors, diversification has proven its long-term value. During the 2008-2009 bear market, however, many different types of investments lost some degree of value at the same time. This may have been one instance where investors felt that diversification failed them, though in reality it did not. While major asset classes were more highly correlated, diversification helped contain portfolio losses.
To illustrate, consider the performance of three hypothetical portfolios in that 2008-2009 time period: a diversified portfolio of 70% stocks, 25% bonds, and 5% short-term investments; a 100% stock portfolio; and an all-cash portfolio.
Diversification helped to limit losses and capture gains during the 2008 financial crisis
Source: Strategic Advisers, Inc. Hypothetical value of assets held in untaxed accounts of $100,000 in an all cash portfolio; a diversified growth portfolio of 49% U.S. stocks, 21% international stocks, 25% bonds, and 5% short-term investments; and all stock-portfolio of 70% U.S. stocks and 30% international stocks.
By the time the market hit its bottom point at the end of February 2009, both the all-stock and the diversified portfolios would have declined. However, the all-stock portfolio lost nearly half its initial value (–49.7%) and the diversified portfolio lost a bit more than a third (35%). Though the diversified portfolio declined, diversification did help to reduce losses compared with the all-stock portfolio. The all-cash portfolio (1.6%) would have outperformed the all-stock and diversified portfolios over this 14-month period, but missed out on gains during times of more stable market activity.
Keeping your money in cash seemed like a good idea in February 2009. However, just five years later, the portfolios looked very different. The all-stock portfolio gained 162.3% and the diversified portfolio gained 99.7%, but the all-cash portfolio brought in a pitiful though predictable return of 0.3%.
What looks like great progress after a market downturn is a little more tempered when you keep the big picture in mind. When we view a longer historic cycle, starting before the bottom in January 2008 through February 2014, the diversified portfolio was only up by a more typical 29.9% and the all-stock portfolio was up by 31.8%. This illustrates what diversification is all about. Diversifying your portfolio won’t necessarily maximize gains in a rising market, but it will capture most of the gains while still protecting your investments from volatility.
Your SYM advisory team works diligently to tailor your portfolio to meet your needs for cash flow, risk tolerance and time horizon. The SYM team stands firmly in support of your managed portfolio, and now is the time to think about your global asset allocation as you consider all of your cash, other investments and especially any highly concentrated stock positions. If you have questions or would like to talk further about asset allocation, your SYM advisory team is here to help.