Diversification is a bit of a buzzword in financial planning circles. You may not know much about investments, yet probably know that that diversification is important even if you don’t know what it means.
So, what is it? And why is it important?
Diversification is a way to spread out investment risk and volatility over a number of different types of investments. In layman’s terms, it is the act of putting your eggs in more baskets than one. It can reach great levels of complexity like purchasing percentages of common stock, preferred stock, municipal bonds, treasury bonds, corporate bonds, junk bonds, commodities, real estate, land, certificates of deposit, cryptocurrencies, art, and on and on ad nauseam. It can also be as ordinary as having a portfolio with one portion of your monies allocated in stocks and another portion sitting in bonds.
One of the many benefits of having a diversified portfolio is that historically certain types of investments tend to remain stable while others are more volatile. Let’s keep it simple and show how this can work with stocks and bonds.
In the most recent coronavirus crash of 2020 notice how the performance of $10,0000 in stocks via the popular Vanguard Total Stock Market ETF compared to $10,000 in bonds via the popular Vanguard Total Bond Market ETF.
You can see that stocks got hammered and bonds remained relatively stable. While this chart shows the volatility of one and stability of the other during this time period, it does not help us see why one might need both and the benefits of having both in a long-term investment plan.
Adding the commonly used 60/40 allocation of stocks and bonds (in this case, 60% in VTI and 40% in BND) to our chart and extending the time period to 1 year makes the importance of diversification clearer. Take a look:
Notice how a 60/40 portfolio did not take as significant a hit that 100% in stocks did yet exceeded the performance of holding 100% in bonds during that time frame. This reveals that one of the purposes of diversification in both stocks and bonds is that it can minimize the severity of risk to the downside in the stock market as it falls while enabling one to continue to capture stock market gains when it rises. Again, let the layman speak, diversification helps you get the best of both worlds.
The above scenario may not look all that appetizing, which is why one year doesn’t tell much of the story. In fact, you normally should not make investment decisions over the short term. Let’s zoom out before the financial crisis of 2008-2009 to get a better sense of how diversification in both stocks and bonds can perform over a longer time frame.
Imagine not being diversified during this time period. Sitting entirely in a money market fund like Fidelity Government Cash Reserves moved up ever-so-slightly, keeping your money in bonds performed ok (quite well actually given lowering interest rates which lead to rising bond prices), but neither of these accomplished anywhere near this 60/40 diversified portfolio’s performance over these years.
Sure, if one was 100% in stocks, the end result looks magnificent, but that crash during the crisis would have been terrifying and it would have been tremendously challenging to stay invested along the way after watching half of it seemingly go up in smoke. To bail entirely on the stock market on the way down and move everything to bonds or cash makes recovering what was lost problematic to say the least. Or what if you needed some of that money due to a life event when the market was at its worst? Not good.
This is the significance of staying diversified. If you don’t diversify you can hogtie yourself to extremes—be it the extremes of highs and lows of stocks, much slimmer gains in bonds, or flatlining cash under the mattress. Extremes can cost you dearly.
Remember the avoidance of loss can also result in the avoidance of gains. Would you like to avoid losing your money? Sure. No one likes losing money. But that question can be asked another way. Would you like to avoid increasing your money? Not so much. Most of us want our monies to grow.
The rub is trying to match your risk tolerance with your financial goals (like retiring and remaining retired, funding children’s education, keeping up with inflation, etc.) and diversification can be a big deal in reaching and—this is utterly critical—sticking with your investment plan to reach those goals. Furthermore, there are all kinds of reasons to own varying percentages of stocks and bonds (at times even none at all) or adding additional types of investments to your portfolio, but the importance is to make goals and develop an investment plan and portfolio that may best enable you to reach them.
Diversify in such a way that you don’t get hogtied to extremes and can standby the pursuit of achieving your financial goals with the right investment mix that suits you. Maybe we can help and check to see if your current strategy is working.