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Here's Why Diversification Matters

Roger Wohlner

Investment diversification is one of the basic building blocks of a solid portfolio. Diversification is the fancy name for the advice: Don't put all of your eggs in one basket. This is the basic principle behind asset allocation, a key element of portfolio diversification.

Finance blogger Ken Faulkenberry defines investment diversification as "a portfolio strategy combining a variety of assets to reduce the overall risk of an investment portfolio."

A basic, diversified portfolio might include several investment categories such as stocks, bond and cash. Your allocation to each of these broad categories should be based upon your investment goals, your tolerance for risk, and your time horizon for needing the use of the money. In short your asset allocation should be an outgrowth of your financial plan.

You might use stocks, bonds, mutual funds, ETFs, private equity and a whole host of asset types in building a diversified portfolio. Let's take a look at how well diversification worked during what many in the financial press have labeled as "The Lost Decade," the years 2000-2009.

Assume a hypothetical investor had $100,000 to invest on January 1, 2000, held his investments through December 31, 2009 and reinvested all distributions. We will also assume the use of Vanguard index mutual funds for our examples.

Investor 1 puts all of her money in the Vanguard 500 Fund which invests in the stocks making up the Standard & Poor's index in their relative weight in the index. How much would it be worth by December 31, 2009? This $100,000 investment would have shrunk to $90,165 for an average annual loss of 1.03 percent. This was truly a lost decade for this investor.

Investor 2 added the following funds to his portfolio in addition to the Vanguard 500:

--Vanguard Small Cap Index

--Vanguard Mid Cap Index

--Vanguard Total International Stock Index

How much would an investment of $100,000 invested equally in each of these four funds have grown to by December 31, 2009? (We are assuming no taxes or rebalancing in this and all examples. The answer is $137,511. This is $47,346 or about 52 percent more than an investment of our investor's cash only in the Vanguard 500 Index.

While the average annualized return of 3.23 percent over the course of the decade is nothing to write home about, it does illustrate the potential benefits of diversification.

Investor 3 added some bonds to her mix. In this case let's add the following funds:

--Pimco Total Return

--T. Rowe Price Short-Term Bond

--American Century Inflation Adjusted Bond

--Templeton Global Bond

If we now divide the investor's $100,000 investment equally among the four equity funds from the prior example and among these four bond funds, by the end of 2009, $100,000 investment has grown to $174,506 or almost double what an investment of $100,000 in the Vanguard 500 Index Fund alone would have yielded. The portfolio's average annual return was 5.72 percent for the decade.

The impact of diversification is clear in this case. Again this example was based on eight funds weighted equally with no rebalancing and the reinvestment of all distributions. This was an unusual decade in that bonds largely held their own or outperformed equities. It is likely that if we performed this same analysis for the ten years ended December 31, 2019 the results would look different, if for no other reason than the fact that bond yields are at historic lows. Nonetheless there are a few things we can take away from this analysis:

The decade was a poor one for large-cap stocks as illustrated by the use of the S&P 500 index fund.

--Small, mid-cap, and international equities outperformed domestic large-cap stocks.

--Diversifying the equity holdings in this example boosted overall portfolio return. Bonds were aided by generally declining interest rates and lower volatility than equities.

--Both of these factors helped their overall return for the decade and really boosted our hypothetical portfolio. Bonds in general have a relatively low correlation to equities, which assisted in mitigating the volatility of our portfolio and enhanced returns.

--Even in this "lost decade" asset allocation helped enhance return.

Implications for the future?

Clearly the period used in the analysis was unique one, a decade that contained market declines (as measured by the S&P 500 index) of 49 percent from March of 2000 through October of 2002 and 57 percent from October of 2007 through early March of 2009. However it seems that market volatility has become the norm rather than the exception so the current decade will likely be an interesting one as well.

A few lessons we can take forward:

--Diversification reduces risk.

--Diversification among assets with low correlations to one another further reduces risk.

--Diversification is important because we have no way of knowing which investments or asset classes will perform well or poorly or when.

The trick, however is to determine what to use in your investment mix and in what percentages. For example, the 30-year tailwind for bonds is likely behind us so their impact upon portfolio returns over the course of the current decade may be minimal.

Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides financial planning and investment advice to individual clients, 401(k) plan sponsors and participants, foundations, and endowments. Roger is active on both Twitter (@rwohlner) and LinkedIn. Check out Roger's popular blog The Chicago Financial Planner where he writes about issues concerning financial planning, investments, and retirement plans.

Note that the mutual funds cited in this article were for example purposes only and does not constitute any sort of recommendation as to the use of these funds or the asset allocation percentages used in the article.

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