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Diversification

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NAPKIN FINANCE

Diversification: Smooth Your Ride

Diversification can help reduce your portfolio’s risk and cushions the market’s bumps.

 

IN BRIEF

In a perfect world, your investments would only go up. In the real world, all investments hit some bumps. However, spreading your money across different types of investments through diversification lessens the effects of those bumps, so you get a steadier ride.

Spreading your bets around can protect your money.

Unless you happen to own a magic wand, diversification can be your best bet for reducing risk in your portfolio. At one extreme, imagine that you only owned one stock in your portfolio. A recession or a few bad business decisions by management could cause the value of your portfolio to drop significantly, and even reach $0. At the other extreme, suppose you owned a small stake in different types of businesses all over the world. Recessions could come and go, but you would probably own a bundle of winners regardless of the market environment.

That’s the hope of diversification: That even when the markets are fluctuating, you’ll still own some investments that at least hold their value or even appreciate. Diversifying can help even out your portfolio’s returns and may help boost performance during those scary downturns. Plus, knowing that you don’t hold all your eggs in one basket can make it easier to stick with your plan when stock prices drop, which is one of the essentials to earning a solid long-term return.

Broader diversification offers better protection.

The more widely you invest your assets, the better your chances of holding something that zigs when the rest of the market zags. Consider diversifying across a number of dimensions:

  • Mix different asset classes. Stocks provide growth, while bonds offer stability. For some investors, holding alternative asset classes, such as real estate or commodities, may also be appropriate.
  • Invest in an assortment of industries. Different industries may go through boom and bust cycles at different times. Aim for a broad cross-section of the economy.
  • Spread your bets around the globe. Diversifying geographically allows you to capture the returns of higher-growth nations and can protect you when the U.S. economy stumbles.
  • Hold a range of individual securities. A fully diversified portfolio may contain hundreds or even thousands of securities. Mutual funds and exchange-traded funds can offer such broad diversification without the headache of tracking a sprawling portfolio.

In turbulent times, a diversified portfolio can provide a steadier ride.

Markets have given investors a bumpy ride over the past 15 years—a period that included a major market downturn, significant geopolitical upheaval and many natural disasters. The chart below shows annual returns for major asset classes during this period. Note that each asset class spent at least one year as one of the worst two performers or top two performers with one exception: A well-diversified portfolio of stocks, bonds, and other assets performed in the middle of the pack every year, ultimately returning more than 8% annualized over the period. Despite the many scary headlines of the past 15 years, cash was the worst-performing asset in more years than any other asset class.

Asset class returns chart from 2003- 2017

Source: J.P. Morgan Asset Management, Guide to the Markets, as of June 30, 2018.

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