The Basics Of Diversification, And Why It’s Important

By Jon L. Ten Haagen

Diversification does not mean having five large cap value stocks or 10 small cap stocks in your portfolio. Diversification is spreading your investments over many asset classes. Diversification always makes sense. Markets go up and markets go down. That is what they do. Spreading money over several kinds of investments may help you achieve growth throughout market cycles and mitigate the effects of market swings short term and long term.

No asset class is the top performer all the time. The best performing asset classes change dramatically from year to year. In 2006, real estate investment trusts, or REITs, were the top performer and in 2007 they were at the bottom. In 2007, foreign stocks performed best, and in 2008, they were at the bottom in performance.

In 2008, investment-grade bonds were the best performers, followed by high-yield bonds the following year and small-growth stocks in 2010 and investment-grade bonds once again in 2011.

The point is, broad diversification gives you a better chance of achieving your long-term goals.

When markets are especially strong or weak, diversification somehow doesn’t seem quite as important. Until it changes, and hindsight reminds us it would be smart to diversify.

Failing to diversify properly can mean not only losing money when a segment deteriorates, but also losing out when it improves.

The concept of diversification is that investors can improve their risk-return profile by investing in multiple investments verse concentration the balance in a single investment. During the last bull market, many investors assumed that diversification would sacrifice performance. Now, amid economic uncertainty and a volatile market, many investors are afraid to take cash off the sidelines.

Simply put, investors act on emotion. This can cause them to abandon their long-term financial plans–short selling, chasing returns and making lump-sum transactions.

The simplest reason for diversifying your portfolio is that no one can successfully predict market cycles. If they say they can, they are lying. Occasionally, they are right short term, like a broker clock is right twice a day!

Over the past 20 years, the top performing asset classes have moved between U.S. bonds, U.S. Stocks, REITs and foreign stocks. It is possible to make a case for nearly any asset class coming out on top in a year. Since it’s impossible to know the next top performer, a sound approach is to spread investments among different asset classes.

Focus on the fundamentals. History shows that if you adhere to time-tested basics like diversification, you may be poised to enjoy returns throughout market cycles. Here are some other basics you should keep in mind. Don’t get caught chasing returns, take a long-term approach, and benefit from dollar-cost averaging.

Do you have the desire, inclination and skills to create a well-diversified portfolio on your own? You may want to consult a Certified Financial Planner with proven money management experience to help you understand your investment objectives and plan a strategy to reach them.