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.
From just $107.88 $24.99 for Kiplinger Personal Finance
Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues
Sign up for Kiplinger’s Free 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.
-
I'm want to give my 3 grandkids $5K each for Christmas.You're comfortably retired and want to give your grandkids a big Christmas check, but their parents are worried they might spend it all. We ask the pros for help.
-
If You're Not Doing Roth Conversions, You Need to Read ThisRoth conversions and other Roth strategies can be complex, but don't dismiss these tax planning tools outright. They could really work for you and your heirs.
-
Could Traditional Retirement Expectations Be Killing Us?A retirement psychologist makes the case: A fulfilling retirement begins with a blueprint for living, rather than simply the accumulation of a large nest egg.
-
I'm a Financial Planner: If You're Not Doing Roth Conversions, You Need to Read This
Roth conversions and other Roth strategies can be complex, but don't dismiss these tax planning tools outright. They could really work for you and your heirs.
-
Could Traditional Retirement Expectations Be Killing Us? A Retirement Psychologist Makes the Case
A retirement psychologist makes the case: A fulfilling retirement begins with a blueprint for living, rather than simply the accumulation of a large nest egg.
-
I'm a Financial Adviser: This Is How You Can Adapt to Social Security UncertaintyRather than letting the unknowns make you anxious, focus on building a flexible income strategy that can adapt to possible future Social Security changes.
-
I'm a Financial Planner for Millionaires: Here's How to Give Your Kids Cash Gifts Without Triggering IRS PaperworkMost people can gift large sums without paying tax or filing a return, especially by structuring gifts across two tax years or splitting gifts with a spouse.
-
'Boomer Candy' Investments Might Seem Sweet, But They Can Have a Sour AftertasteProducts such as index annuities, structured notes and buffered ETFs might seem appealing, but sometimes they can rob you of flexibility and trap your capital.
-
AI Stocks Lead Nasdaq's 398-Point Nosedive: Stock Market TodayThe major stock market indexes do not yet reflect the bullish tendencies of sector rotation and broadening participation.
-
Quick Question: Are You Planning for a 20-Year Retirement or a 30-Year Retirement?You probably should be planning for a much longer retirement than you are. To avoid running out of retirement savings, you really need to make a plan.
-
Don't Get Caught by the Medicare Tax Torpedo: A Retirement Expert's Tips to Steer ClearBetter beware, because if you go even $1 over an important income threshold, your Medicare premiums could rise exponentially due to IRMAA surcharges.
