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The Potential Benefits of Diversification

“Don’t put all your eggs in one basket” is a common expression that most people have heard in their lifetime. Simply put it means don’t risk losing everything by putting all your hard work or money into any one place.

To practice this in the context of investing means diversification – the strategy of holding more than one type of investment , such as stocks, bonds, or cash, in a portfolio to reduce the overall risk of the portfolio. In addition, an investor can diversify among their stock holdings by buying a combination of large, small, or international stocks, or among their bond holdings by buying short-term and long-term bonds, government bonds, or high and low-quality bonds.

The chart below displays annual returns for five major assets classes as well as a hypothetical diversified portfolio equally-weighted among those asset classes, since 1994. As you can see, it is often last year’s winner that can become next year’s loser, and the ability to forecast these winners and losers is often a guessing game that can leave investors frustrated. Note that while the hypothetical portfolio never experienced the highest return in a given year, neither did it suffer the lowest return.

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A diversification strategy reduces risk because stocks, bonds, and cash generally do not react identically in changing economic or market conditions. Of course diversification does not eliminate the risk of experiencing investment losses; however, by investing in a mix of these investments, investors may be able to insulate their portfolios from major downswings in any one investment and dampen the potential extreme fluctuations resulting from single asset class volatility.

It is often stated that over the long run, it is common for a more risky investment, such as stocks, to outperform a less risky diversified portfolio of stocks, bonds, and cash. However, one of the main advantages of diversification is reducing risk, not necessarily increasing return. The benefits of diversification became more apparent over a shorter time period, such as the 2007-2009 banking and credit crisis. Investors who had portfolios composed only of stocks likely suffered large losses, while those who had bonds and cash mixed into their portfolios experienced less dramatic fluctuations in value.

How diversified are your investments? We invite you to visit our website to learn about the benefits of investing in a diversified portfolio, managed for you by TradeKing Advisors.

 

About the Data
Small stocks are represented by the Ibbotson® Small Company Stock Index. Large stocks are represented by the Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general, government bonds by the 20-year U.S. government bond, Treasury bills by the 30-day U.S. Treasury bill, and international stocks by the Morgan Stanley Capital International Europe, Australasia, and Far East (EAFE®) Index. Indexes are unmanaged and an investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs. The diversified portfolio is equally weighted between small stocks, large stocks, long-term government bonds, Treasury bills, and international stocks. The portfolio is not representative of a portfolio offered by TradeKing Advisors and is only hypothetical. Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. Used with permission. © 2014 Morningstar, Inc. All rights reserved.
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