What Diversification Can Do for You (and Your Assets)

Stock investors love a bull market. But what about when the stock market heads south, like it did less than a decade ago, during the Great Recession? As an investor, would you be content to enjoy much, but perhaps not all, of the gains a bull market provides, while also gaining an extra measure of protection to preserve the value of your assets in the face of a stock market decline? As someone who has worked long and hard to build a financial nest egg, would you prefer that nest egg got a smoother, more predictable ride rather than subjecting it entirely to the volatile whims of the stock market?

The dual priorities of growing your assets while also protecting them from downside risk represent the premise behind, and the justification for, the fundamental investing concept known as diversification. Diversification — maintaining an appropriately balanced mix of assets such that they have the opportunity to grow while being protected from market downturns and other factors that may be out of your control — is an approach that, according to financial professionals, can benefit every investor, particularly now, with high volatility exposing assets to a new level of risk.

“Asset diversification is the outgrowth of the saying ‘Don't put all of your eggs in one basket,’" explains Elliot Herman, a Certified Financial Planner™ with PRW Wealth Management in Quincy, Mass. “If done properly, one should normally not outperform the market or underperform the market, but will rather find a happy place in the middle. The idea is to smooth the ride that inevitably gets bumpy and can lead to emotional decisions that derail good long-term plans.”

The stock market moves in cycles that can subject investors to a rollercoaster ride of extreme highs and lows. For example, the extended bull market that has seen stocks gain 270% since March 2009, according to LPL Financial Research, was preceded by an extreme bear market in which stocks plummeted 56% in a matter of just 17 months. As Herman notes, these wild swings — especially on the downside — can prompt people to panic in the moment and do things that aren’t in their long-term best interests, such as selling their interest in an investment when it’s value is sharply lower, instead of having the patience to allow that investment to recover.

Diversification helps investors avoid the extreme lows while still partaking in the highs, if not the peaks, and thus, also hopefully helps them to avoid ill-advised decisions. But what exactly does diversification entail? When a portfolio of assets, including retirement accounts, taxable investment portfolios, real estate holdings, cash reserves and more, is appropriately diversified, some of the individual asset classes inside the portfolio will, by design, behave differently from the others over time instead of moving in lockstep. Diversification thus is a matter of building a mix of assets whose behavior doesn’t always correlate; that is, that when the value of one asset class is down, the value of another asset class is up. This use of non-correlated assets is designed to level out the peaks and valleys in the overall performance of a person’s full portfolio of assets.

“Having investments that zig when the market zags or do not capture the full swings of the markets in either direction are key to providing diversification,” Herman explains.

What’s the appropriate asset allocation, the right balance between growth and protection, risk and reward? That depends mostly on the individual and their needs, goals and phase in life. A person in their twenties or thirties is probably able to take on greater investment risk in the quest for growth than a person close to or already in retirement, because the younger person’s portfolio likely has more time to recover from market downturns. As a result, a heavily growth-focused asset allocation approach that’s appropriate for a 30-something person might be too risky for a retiree.

How is diversification achieved? By managing how assets are allocated across asset categories as well as within asset categories. Most peoples’ portfolios include stocks, whose main job is to provide growth, and fixed investments such as bonds, whose main function is to provide protection via a predictable return and income stream. Some portfolios also may include real estate and so-called alternative investments, a catch-all category for anything that doesn’t fit in the other categories, like hedge funds and commodities, for example. Diversification is achieved at this level by spreading assets appropriately across these asset classes.

Diversification within specific assets classes is also important. In the stock category, that might mean spreading assets across large- through small-cap, growth and value, international and domestic, emerging markets, etc. The same applies to bonds, according to Herman; generally it’s good to have a variety of different types, including Treasury bonds, corporate bonds, municipal bonds and the like, with varying durations and risk levels.

One rule of thumb in financial circles is to be sure no more than 5% of an investment portfolio is attributable to a single investment — shares of stock in one company (including the one that employs you), as an example, or investments in a commodity such as gold, or shares of a mutual fund representing a distinct sector, such as energy or utilities. Again, it’s about taking care not to put too many eggs in one basket.

Because markets fluctuate and personal circumstances change, diversification is a moving target. Over time, says Herman, a person’s asset allocation needs to adjust to reflect shifts in the value of their holdings in various asset classes, and to changes in their needs, goals and circumstances. It is therefore crucial to periodically revisit — at least once a year, most personal finance experts recommend — how your assets are allocated, then to adjust as necessary. This adjusting of assets is called rebalancing, which entails shifting dollars among various investments inside a portfolio to rectify any imbalance caused by movements in the value of holdings inside the portfolio.

Managing the various aspects of diversification, from determining an appropriate asset allocation strategy to executing that strategy to revisiting it and rebalancing assets, can be a complex undertaking. And since this is your retirement nest egg, the stakes are high, which is why many people decide to turn to a financial professional for guidance. To find one in your area, check out the Financial Planning Association’s searchable national database of personal finance experts at www.PlannerSearch.org.