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By Alex Fishman - July 2, 2018
Diversification is often touted as the most important strategy in an investor's toolkit. But if you read the fine print in your investment or financial education materials, you'd often see this line:
Diversification does not assure a profit nor does it protect against loss of principal.
If some of the investments in your diversified portfolio are gaining during a particular market environment and a few others aren't keeping up (or are losing value), everything might actually be going according to plan.
How can that be?
Let's dive further into what diversification is, and what it isn't.
Diversification simply means spreading out your money over multiple asset classes (categories of investments) that respond differently to market changes. At a high level, those types of asset classes include stocks, bonds and cash positions. Each of those asset classes has its own characteristics: stocks and bonds may perform differently when the economy is booming or slowing down, when interest rates rise or fall or when political events make headlines.
Investing your money with different financial institutions or product types (stocks, mutual funds, exchange-traded funds, etc.) is NOT diversification. These variations won't help if your investments all act the same when markets move.
A portfolio can have a variety of underlying investments but still not be properly diversified.
Source: American Century Investments®. The hypothetical scenario is an example of what a diversified portfolio might look like.
Diversification should go beyond the general categories of stocks, bonds and cash. Each of these can be split further into more specialized categories:
Large: McDonald's, Exxon Mobil
Medium: Mattel, Royal Caribbean
Small: Barnes & Noble, Etsy
U.S.: Apple, Walmart
Non-U.S.: Nestle, Samsung
Energy, health care, real estate, information technology, consumer staples, financials, etc.
Style (stock-picking philosophy)
Growth: stocks exhibiting growth potential
Value: "bargain" stocks expected to increase in value
U.S. vs. non-U.S.
Developed vs. emerging markets
Not a comprehensive list of stock, bond or cash categories. References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
Some investments have more growth potential than others, so why not stick with all stocks, for example? Because growth potential can go hand in hand with risk. For example, emerging markets stocks were among the top performers last year; they also lost more than half of their value in 2008* and experienced wide swings in the years between.
Most investors aren't comfortable with such uncertainty, but research shows that no asset has a repeatable performance pattern. Owning different asset classes, however, can help prepare you for various market conditions and may help provide more consistent, less volatile returns over time.
Diversified portfolios have the potential to benefit from some the big gains (but not all) of their underlying assets and experience just some (and not all) of the big losses. The end goal is smoother pattern of performance and less anxiety for you.
Diversifying your investments may seem complicated if you try to research and select each type of asset on your own. Most mutual funds allow you to spread your money across securities in a specific category.
You can go beyond that with a fund-of-funds investment, which provides a mix of funds that cover multiple asset categories in a single product. More importantly, fund managers will carefully select and monitor the investments in these portfolios for their shareholders.
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* Emerging markets stocks, as measured by the MSCI Emerging Markets Index, had an annual return of 37.75% in 2017 and -52.18% in 2008.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.