You've probably heard the phrase,
"don't put all your eggs in one basket".
This is one of the most common analogies used
in investing when talking about diversification.
Many investors might think the more stocks
they own, the more they’re diversified.
While that might be true to a certain degree, true
diversification involves investing in a variety of
asset classes, not just one product like stocks.
And within each asset class, specific investments
can be selected based on different factors like
industry, sector, currency, and even geography!
The goal of diversification is to minimize
risk while allowing for your portfolio to grow.
But does this strategy work?
Let's take a look…
This graphic shows the annual return for
different asset classes from 2007 to 2022.
[call out for reference of data source?]
The white boxes represent a basic diversified
portfolio with investments from each asset
category listed and is rebalanced annually.
As you can see, that portfolio example
is typically in the middle of the road
when it comes to performance…
If we look at the last column
here … this shows the volatility for
each asset class during the same period
The diversification of investments
within this portfolio example seems
to effectively manage risk and volatility.
Only cash and fixed income were less volatile
than our diversified portfolio.
If we look specifically at the 2008
financial crisis, again, only cash and
fixed income outperformed the portfolio.
So, we can conclude that during the
last 15 years, the diversification
strategy can be considered successful.
Over this time, a diversified portfolio
would've generated six-point-one per cent profit a
year while ranking third in minimizing volatility.
This can be appealing to short-term investors
who try to minimize their potential losses before
they need to access to their money.
Let's look at 2008 as an example…
Specifically, the "large cap" portfolio
which mirrors the S and P 500.
If a large cap investor needed money
after the financial crisis, they would have needed
to sell their stocks after a 37-per cent loss.
Compare this to an investor with a
diversified portfolio who would've
lost only 25-point-four- per cent.
So now for the question that's
likely on your mind: why doesn't every
investor have a diversified portfolio?
Well, first - diversification isn't
the only investing strategy around…
And keep in mind that some investors are
comfortable taking on more risk if it means
they have a greater chance of making more money.
These more risk tolerant investors might narrow
their focus on asset classes that they
believe will perform stronger than others.
Or – in extreme examples – they might narrow their
focus even further and buy and sell a handful of
individual investments, like a stock picker.
The risk though is that it's hard to predict
which asset classes or individual stocks are
going to be top performers year over year…
It also might require a fair amount
of time and effort in research...
And there's no guarantee
their picks will be good ones!
At the end of 2021, one might have thought a
portfolio of large cap equities or REITs would
be a good asset class to invest
in based on their performance …
But so far in 2022, they're among
the underperforming asset classes.
Ok, so we've established that diversification
as an investing strategy has worked in the past…
And explained the benefits and
shortfalls of the strategy.
Now it's time for you to decide if it's the best
strategy for you based on your investing goals
and risk tolerance.
And if it is…
You can review your current portfolio
diversification on WebBroker…
And adjust your asset mix as needed!
Just remember that portfolio management is an
ongoing process – so it's good practice to review
your investment goals and portfolio regularly.
