Broker Check

Value of Diversification

August 31, 2020
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A few weeks ago we addressed the question, "What is The Market Anyway?" As you're probably aware, there are in fact many different 'markets' and sectors within the market. Examples include U.S. Large Cap, Emerging Markets, Global Real Estate and U.S. Bonds. The performance of each of these market sectors varies every year. The following chart illustrates annual sector returns for the past 10 years.
Source: Russell Investments. Annualized Returns. Balanced: 30% Russell 3000 index, 35% Bloomberg Barclays US Aggregate Bond Index, 20% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 5% FTSE EPRA/NAREIT Developed Index, 5% Bloomberg Commodity Index.
Many investors fall into the trap of buying into the latest winner. It's hard not to - you see the performance of the top asset class and want to participate. U.S. Large Cap (in blue) is a great example. Over the last 10 years (2009-2019) it has been the top performing sector. So, why not just allocate 100% of your funds the that asset class?
 
The answer is clear: over the previous 10 years (1999 - 2009) the same U.S. Large Cap was the work performing asset class. Chasing winners typically violates two broad investing rules: buying high and selling low and "putting all your eggs in one basket". That's where the principal of diversification comes in. Rather than betting on a single asset class, we spread our dollars - and risk - among many different classes. The goal is to help reduce the volatility you experience.*
 
What will the winning asset class be over the next 10 years? We don't know. And because we don't know we utilize the same principal of diversification. As the chart above illustrates, the yellow Balanced (or diversified) portfolio helps smooth out the ride over the long term.
*Diversification does not assure a profit or protect against a loss. Past performance is no guarantee of future results.