Diversification comes from a very simple idea…don’t put all your eggs in the same basket.
2021 Performance Chart represents asset allocation quilt over the past 10 years:
EW = an equal-weighted portfolio of every asset on the quilt
The gap between the best and worst performing asset classes is huge. The best performing asset class (REITs) outperformed the worst (Emerging Markets (EM)) by more than 44% in 2021.
The average difference between the best and worst performer of the 10 asset classes used here since 2012 is 20.2%. The biggest difference between top and bottom performers came in 2013 when small cap stocks outperformed commodities by more than 52%.
This tells us diversification is not dead by a long shot but it also shows how many opportunities investors have to be either really right or really wrong if they go to the extremes in any one asset class or region.
The consistency of the S&P 500 is impressive over the ten year period. For this entire 10 year period large cap U.S. stocks have been in the top 3 of these asset classes every single year, including the top slot for two of the past three years.
And the crazy thing about the outperformance is the volatility of annual returns is lower for the S&P than its equity counterparts:
- S&P 500: 12.3%
- Small caps: 14.7%
- Mid caps: 14.0%
- Foreign stocks: 14.8%
- Emerging markets: 18.8%
Every type of investment has risk attached to it. This risk can evolve over time, but it exists. Risk is something an investor should always consider.
For investors, one of the most important considerations is how to manage investing and portfolio risk. Diversification is a proven and efficient way to manage investment risks.
Diversification is the practice of building a portfolio with a variety of investments that have different expected risks and returns. Diversification aims at spreading investments across a variety of asset classes.
The benefit of diversification in your investment portfolio is that it helps smooth portfolio returns over time: as one investment increases, it offsets losses from another investment, thereby providing more regular returns on investment under various economic and market conditions.
You can diversify your portfolio by investing an equally-weighted return for all 10 asset classes (minus EW) listed in the Performance Chart. These asset classes have varying levels of risk and returns, so including investments across asset classes will help you create a diversified portfolio. Diversified investment portfolios generally contain at least two asset classes.
Diversification can help protect you against events that would affect specific investments. Yet, diversification means that every year you miss out on both home runs and strikeouts regarding your investments. Thus, diversification means that your portfolio is never going to be the best performer in a given year. The equal-weight portfolio is basically always in the middle of the pack.
But a fully diversified portfolio of all ten asset classes is never the worst performance either.
This is the trade-off you make when trying to control for risk. Being diversified means always investing in both the best and worst performers each year. But, you will never having the best or worst performance in your portfolio.
Most investors know diversification is a smart move and is a key part of risk management, with the goal to preserve your portfolio’s value.
Diversification does not guarantee returns or protect against losses and can help mitigate some, but not all, risk. For example, systematic risks – which include inflation, interest rates or geopolitical events – can cause instability in markets and affect the broader economy and market overall.
References:
- https://awealthofcommonsense.com/2022/01/updating-my-favorite-performance-chart-for-2021/
- https://www.usbank.com/financialiq/invest-your-money/investment-strategies/diversification-strategies-for-your-investment-portfolio.html