The Surprising Truth about Diversification

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 101

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.

It Looks Like It's Diversified, but…

A portfolio can have a variety of underlying investments but still not be properly diversified.

Diversification should go beyond the general categories of stocks, bonds and cash. Each of these can be split further into more specialized categories:

Seek a Smoother Ride Overall

Some investments have more growth potential than others, so why not stick with all stocks, for instance? Because growth can go hand in hand with risk. For example, emerging markets stocks were among the top performers in 2017, gaining 37.75%; the very next year, they lost -14.57%. In 2019, emerging markets stocks were up 18.42%, but they weren’t even close to being the top performers for the year.{sup}1{/sup}

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.

One Option: All-in-One Diversification

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.