The Importance of Diversification

You’re probably well aware of the saying “don’t put all of your eggs in one basket,” right? Well, this applies perfectly to the world of investing and how to best manage the risk associated with your investment accounts. Around here, we believe in the power of index investing, which allows you the opportunity to invest in an entire market indice (like the S&P 500) at almost no cost (usually around .04%), and achieve immediate diversification. You hardly even need to lift a finger!

Now, the reason diversification is so important is because it is impossible to predict the future and which investment market is going to be the best performer. Many investment “gurus” and stock pickers try to attempt this, and fail miserably in the process. To make sure you aren’t taking any unnecessary risk by trying to time the stock market and pick this year’s winners, diversification is your best friend.

When building a diversified investment portfolio, you want to focus on two main areas - diversifying across various asset classes and diversifying within those asset classes. The latter can be done quite easily as mentioned above, by purchasing index funds instead of individual stocks. The former can also be done by spreading your dollars across various index funds that follow indices in different markets. Take a look at the chart below, which shows the investment returns of the following markets - U.S. Large Cap, U.S. Mid Cap, U.S. Small Cap, Real Estate Investment Trusts (REITs), Emerging Markets, International Stocks, Treasury Inflation Protected Securities (TIPS), Bonds, Cash, and Commodities.

 A special thanks to Ben Carlson of  awealthofcommonsense.com  for the quilt.

A special thanks to Ben Carlson of awealthofcommonsense.com for the quilt.

As you can see, there are no patterns as to which market will be this year’s winner, or this year’s loser in total returns. The far right column shows the average returns of each market over the past 10 years, with U.S. Small Cap coming out on top with an average annual return of 10.7% - including 2008! The winner in 2017 was Emerging Markets, but we will likely see a different market come out on top in 2018. Which market will it be? Your guess is as good as mine.

One caveat with diversifying your investments, is that your portfolio is never going to have the highest returns (when compared to the winner of that given year). However, your portfolio is never going to have the lowest returns, either. Diversification is ultimately a pretty boring way to invest, as you can’t brag to your friends about the hot stock you found, but what it does provide is a sustainable long-term growth plan for your investment portfolio.

When it comes to actually implementing your plan to diversify your investments, you have two options. You can either use an All-In-One Fund, like the Vanguard LifeStyle funds, or build a portfolio with individual index funds yourself. The benefit of an all-in-one fund is the ease in which you can invest your money, and never worry about rebalancing or making adjustments again. However, the all-in-one fund will lack in customization abilities, when needed for tax-sensitive accounts or households. Building your own portfolio (or hiring someone to do it for you) provides you the benefits of both diversification and customization for special tax situations.

Source: A Wealth of Common Sense

 

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