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Does Diversification Still Work?

Diversification - InvestingSo you paid attention to the advice to diversify your portfolio. You didn’t just invest in one stock, you invested in many. And not only did you invest in more than one stock, mid-cap stocks, and small-cap stocks in different industries. You also invested in foreign stocks and bonds, maintaining some funds in a money market fund. And you still lost money, so now you’re not so sure diversification really works.

If this is you, you’re not alone. Over the last 10 years, the stock market has experienced two bear markets, testing anyone’s belief in investment principles. But it shouldn’t, for the following reasons:

Diversification reduces risk; it can’t eliminate it. The truth is, all investments are subject to risk. Diversification remains one of the primary ways of managing and reducing investment risk. It does so by spreading your investments not only among different securities, each representing a separate entity, but among different sensitivities to phases of the business cycle and to different cycles altogether. By doing this, you decrease the chances that you’ll lose money because any one issuer has gone out of business or investors have turned sour on a particular industry, sector, or country.

In bad times, a lot of different kinds of investments perform the same way: poorly. Investment professionals track something called “correlation,” which, roughly speaking, measures the degree to which different investments, asset classes, and subasset classes produce gains or losses at the same time. In 2008, for example, four stock sub-asset classes delivered major losses. U.S. large-cap stocks lost 37% of their value, U.S. small-cap stocks lost 34%, the stocks of major developed foreign countries were down 43%, and emerging foreign market stocks lost 53%. Even diversifying by investment style didn’t help – large value stocks in the U.S. lost 39%, while large growth stocks lost 35% (Source: Invesco, 2012).

Diversification is for the long term.
If you need all of your money in the next year, your best bet is to put it all in cash, where your chances of a loss are mostly theoretical. But if you’re planning for the next 10 to 20 years, you’re likely to lose the battle against inflation if you don’t keep some money in stocks.

Diversifying is an alternative to market timing, which very few get right. How confident are you that you know exactly when to move your money out of stocks at the right time to avoid losses and then move back in when stocks start making money again? Most investors haven’t been successful at timing the market that way. The most common mistake is to get out too late and then wait too long to get back in.

Diversifying still avoids the deepest possible losses. 2008 was, we’ve noted, a very bad year for stocks. But the total U.S. bond market, including Treasuries and corporate, returned 5.24% that same year, and Treasuries increased 12.39% (Source: Invesco, 2012). If you’d had 40% of your money in bonds, that loss would have been trimmed to 20.1% – a reduction of nearly half.

If you’re still not convinced that diversification works, look at this way: if you’ve been investing for a long time, you know that the issue isn’t that the stock market hasn’t produced a positive return recently, but that it has been below what you’re used to. For decades, we’ve been taught that stocks return, on average, about 10% a year; but for the past 10 years, that number has been about 5% (Sources: Invesco, 2012). Even if the stock market continues to perform that way, diversification still protects your portfolio from the worst possible losses.

Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

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