Investors: Don’t Sleep on Portfolio Diversification

With stocks in a bear market, bonds offering little more than “less negative” returns, and cryptocurrency facing a serious reckoning, the first half of 2022 should remind investors that a diversified portfolio is going to be necessary in the years ahead. Overexposure to any particular stock or stock sector can lead to crushing portfolio losses, which can have the effect of derailing your investing momentum or worse — putting your retirement in jeopardy.

Let’s take a moment to revisit why diversification remains vitally important to your investing success.

Diversification: A quick review

To “diversify your portfolio” is another way of saying that you adequately spread your money across several different investments. While it’s great to make money investing, not losing money should also be a central consideration. Diversification serves to limit risk.

Concentrated stock positions — for example, if you were to hold all of your money in Apple stock — link your financial future to the performance of a single company, which exposes you to undue risk. Adding more stocks in different industries is likely to give you an adequate return, while also reducing the chance of losing serious amounts of money.

Index funds: A simple solution

If you make “all or nothing” stock or crypto bets, you’re probably taking far more risk than you realize. This is why broad-based, market-tracking index funds can make a lot of sense for retail investors.

Index funds follow entire indices, like the S&P 500 or the Russell 2000, which are comprised of hundreds of companies in different sectors. Total market funds, like the Vanguard Total Stock Market Index Fund ETF (NYSEMKT: VTI), track even more companies and can be thought of as several index funds rolled into one.

Basic index funds can do wonders for investors by bundling stocks together in easy-to-purchase and easy-to-manage securities. These funds also build in diversification, so you won’t need to worry if any one company — or even sector — experiences poor returns over a certain period of time.

Image source: Getty Images.

Diversification in 2022

As the below chart shows, a portfolio heavy in growth stocks (like most of the tech companies) severely underperformed a portfolio of value stocks from the beginning of this year until now:

VTV data by YCharts.

An investor who made a big growth-stock bet at the beginning of the year would have had their position cut by about one-third, while a value-only investor would be down just over 10%.

The middle line, which represents all large-cap stocks (both value and growth), unsurprisingly displayed an average result. While losing over 20% of your money isn’t anything to be happy about, an S&P 500 investor avoided a much worse outcome by committing to diversification.

This is all to say that spreading your money around matters and can help avoid catastrophic outcomes, even if markets have fallen broadly. An investor who put their money in only a few growth stocks could be down far more than 32% — a scenario that could have been taken off the table with proper asset allocation and advance planning.

Recommit to your asset allocation

To survive in an environment with low expected returns, you’ll need to recommit to a diversified portfolio through sensible asset allocation. Put another way, consider allocating a percentage of your money to different asset classes and sticking to your plan over time. Too much money in any one asset class can spell disaster, especially in a scenario where nobody knows what will happen next.

The risk of financial ruin can be limited through diversification, which can help limit the volatility within your portfolio. Take the time to be deliberate and intentional when it comes to allocating your money. The future you will be grateful.

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Sam Swenson, CFA, CPA has positions in Vanguard Total Stock Market ETF. The Motley Fool has positions in and recommends Apple and Vanguard Total Stock Market ETF. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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