Delving into the Merits of Diversification

Written by Nate Hardcastle
Published by Fidelity Investor's Quarterly – June 11, 2010

Why this time-tested investing strategy still works.

For decades, investors have relied on diversification to build portfolios with a balance of risk and return potential that is appropriate for their individual needs. But during the stock market collapse between September 2008 and early March 2009, many market participants suffered significant losses — including many who held well-diversified portfolios. Although many investors stayed the course, others began questioning the value of spreading their investments among a wide variety of assets. Some even took an extreme approach by abandoning diversification altogether and shifted their assets to cash in order to prevent further losses.

But, to paraphrase Mark Twain, reports of diversification’s demise are premature. In mid-March 2009, the stock market started an upward climb and the S&P 500® Index went on to gain 26.5% for the year, as of December 31, 2009.¹ Many investors who maintained diversified portfolios subsequently made a lot of headway and earned back some of their losses — but those who moved out of the market and into cash missed out on the market upswing.

“When building and maintaining a portfolio, it’s important to take a long-term view — not base it on what your strategy has done for you over the past six months,” says Robert Macdonald, senior vice president and director of financial solutions at Strategic Advisers, Inc., in Boston, Massachusetts.

The principles behind diversification

First, let’s review the theory behind diversification, which is based on two investing principles. One is the fact that different types of investments offer a different balance of risk and reward. Assets that offer more growth typically have a greater range of potential outcomes, possibly including significant declines. For example, stocks have stronger return potential than cash, but are more likely to post severe losses (or large gains) in a given year.

Diversifying a portfolio allows you to combine investments with different risk/reward profiles to provide a balance of risk and potential return that suits your individual needs. Say you want to pursue strong returns and are able to accept significant risk: You might hold a stock-heavy portfolio, with relatively little in bonds or short-term investments. Alternatively, if you’re more concerned with protecting your principal, you may decide to overweight in bonds and short-term investments and hold less in stocks.

The second diversification principle is known as “correlation,” which means that returns of various investment types often move in different patterns. The higher the correlation between two assets, the more their returns tend to move in tandem. Conversely, two assets with low correlations aren’t likely to gain or lose value at the same time.

A well-diversified portfolio holds a mix of investments that are not perfectly positively correlated and ideally have low correlations. Some portfolio holdings are likely to climb when others fall, helping smooth out returns. By reducing volatility, diversification helps reduce the risk a portfolio must take on to generate a given level of expected return. Keep in mind, however, that diversification and asset allocation neither ensure a profit nor guarantee against a loss.

The first tier of diversification: asset allocation

Investors typically put diversification into practice on two levels. The first, known as asset allocation, involves spreading investments among different asset classes. The major asset classes are equities, bonds, and short-term investments. These include stocks of different sizes, international equities, various types of bonds and cash investments, and in some cases real estate, commodities, and other categories. Asset allocation is the process of determining which asset classes to include in a portfolio — and in what percentages — to generate a particular balance of risk and potential reward. Three primary factors should influence the asset allocation approach you decide to take:

1. Investment Time Horizon. First, you need to decide what your investing goals are and determine how much time you have to save for each one. If you are young and saving toward retirement, you will likely have a long-term outlook and may be able to handle more risk. If you are older and closer to retirement, you may have both short-term goals (for early retirement needs) and longer-term goals (for years far down the road), so you may want to be exposed to less risk. You’ll then want to decide what types of investments will help you best meet your goals, based on your time horizon.

Of all the asset classes, stocks have historically offered the best chance to outperform inflation over long periods. What’s more, the chance of net losses is lower the longer stocks are held. Consider the following table, which shows the best and worst annualized returns for stocks, bonds, and cash investments during 1-, 10- and 20-year rolling periods between 1926 and 2008.

As you can see, the range of stock returns has declined dramatically over longer holding periods. This fact, combined with stocks’ potential to beat inflation over long periods of time, means you may want a larger stock allocation in your portfolio if you have many years until you’ll need to draw on your savings. As you draw closer to your goal, you may want to gradually shift to a heavier weighting in bonds and cash, which typically pose less risk than stocks over shorter periods.

2. Emotional tolerance for investment risk. Asset allocation also has an emotional component for many investors. The larger your allocation to stocks, the more volatility your portfolio is likely to exhibit. If your portfolio has more risk than you can tolerate, you may be tempted to abandon your asset allocation in favor of more conservative investments when the market declines. Doing so is likely to undercut your long-term returns, because you may not be invested in stocks when they rebound. Indeed, a recent Fidelity study² found that converting all assets to cash during a market decline had a severely negative impact on investors’ ability to reach long-term goals, even if they returned to their asset allocation after the market stabilized. “A plan won’t work if someone is emotionally incapable of sticking with it over time,” says Macdonald.

3. Financial situation. Your household’s financial circumstances — including existing savings, earning power, financial responsibilities, and debt — should also factor into your asset allocation decisions. In general, the greater your need for liquidity, the more you may wish to hold in short-term assets, such as money markets, CDs, and cash. A financial professional can help you determine how your personal circumstances influence your asset allocation choices.

Why asset allocation still works

A closer look at recent history shows that an appropriate asset allocation continued to provide volatility-reducing benefits during the market downturn, if to a lesser extent than it had in the past. While stocks, as measured by the S&P 500® Index, fell some 57% between late 2007 and early 2009,³ Treasury bonds gained 21%,⁴ and short-term investments produced small, positive returns⁵ — helping a well-diversified portfolio mitigate some of the effects of the bear market.

Indeed, Fidelity compared the results of two hypothetical portfolios during the worst of the downturn, which lasted between September 2008, and February 2009.⁶ One portfolio held all stocks, while the other held 70% stocks, 25% bonds, and 5% short-term investments. While the all-stock portfolio would have lost nearly half its value, the portfolio with all three asset classes represented would have declined by about 33% — a significant hit, to be sure, but potentially manageable for an investor with many years to go before drawing on his or her assets.

The trouble with many investors’ asset allocations had less to do with asset allocation itself, and more to do with its misuse. Following a five-year bull market from 2002 to 2007, many investors held more in stocks than was appropriate for their time horizon and risk tolerance. Then, when the market started to decline, the short-term risks of stocks proved far more serious than investors imagined. “I think people might have over-perceived the immunizing effect of asset allocation,” says Robert Macdonald. “Asset allocation may not immunize you from risk during every time period within the span of your time horizon, but it will provide a great deal of value over the longer term.”

“Before abandoning asset allocation because you had large losses, first check whether your allocation really was appropriate for you,” adds Jonathan Citrin, founder and CEO of investment advisory firm CitrinGroup in Southfield, Michigan.

The second tier of diversification: security selection

The second stage of diversification involves choosing individual investments within each of the asset classes in the portfolio. Selecting a variety of securities within each asset class helps take advantage of the different correlations offered by different types of investments.

For example, a diversified portfolio may include large-cap stocks in every sector of the economy, including health care, technology, energy, consumer staples, and so on. Stocks in different sectors often post very different performance in different market environments, so holding securities from each sector can therefore help reduce a portfolio’s risk, compared to a portfolio that’s concentrated in only a few sectors.

Each asset class contains a large array of individual investments. The stock and bond markets include:

		Stocks — issued by large-, medium-, and small-sized firms across all industries, in the U.S. and in foreign countries, including relatively stable, slow-growing firms and rapidly expanding companies.
		Bonds — issued by the U.S. Treasury Department and other U.S. government agencies, stalwart blue-chip public companies and more risky start-ups, U.S. states and municipalities, and foreign governments and corporations.

Diversification helps provide a way to benefit from the variety within each asset class. For example, if your equity portfolio is well diversified, some of your stock holdings are likely to rise when others fall — reducing short-term losses. Meanwhile, you’ll maintain exposure to the long-term growth potential of stocks. Consider the bear market between 2000 and 2002. The broad stock market lost 49%, as measured by the S&P 500® Index.⁷ But certain types of investments held up well: Small, value-priced shares gained 1.6%,⁸ while real estate investment trusts (REITs) jumped 34.4%.⁹ Many investors with well-diversified portfolios held exposure to these stock categories, helping to cushion their overall returns. Holding a variety of bond types may similarly reduce your bond portfolio’s fluctuations.

One easy and convenient way to diversify a portfolio is through mutual funds. A mutual fund is an investment that pools together many securities into one investment vehicle. Individual investments in the funds are aggregated to purchase securities consistent with the fund’s objective. There’s a mutual fund for most investment objectives — from those that seek capital appreciation to those that seek income or capital preservation. There are also funds that invest in multiple asset classes so investors can have a well-diversified portfolio with as little as one to three funds. They are managed by professional portfolio managers who either actively manage the fund’s investments, or "passively" manage them to try and track the returns of a specific market index. Mutual funds can offer investors the advantages of diversification and professional management if they do not have the time or the expertise to do it themselves.

The staying power of diversification

It’s true that stock diversification provided little protection during the worst months of the downturn: Between September 15, 2008, and March 9, 2009, small caps fell 51.9%,⁸ foreign stocks fell 45.3%,¹⁰ and the best-performing U.S. economic sector, consumer staples, lost 31% (the worst-performing sector, financials, fell 83%).³ With every type of stock falling, there was nothing to cushion equity investors’ losses.

Such short-term disruptions are part of market history. Diversification historically has not worked as well during periods of severe stress in the financial system — and the months following the failure of Lehman Brothers on September 15, 2008, encapsulated the greatest threat to the global financial system since the 1930s.

But, after each previous episode of synchronized losses, various types of stocks and bonds reverted to their distinct patterns, renewing diversification’s benefits.

“The recent environment, in which most assets declined simultaneously, was severe — but it was not without precedent,” notes Macdonald. “We’ve seen similar things happen during other major crises. But each time, diversification’s benefits have subsequently returned.”

Diversification isn’t a magic bullet. If you’re a long-term investor, you can expect to experience distinct periods in which many types of investments fall in tandem. But those periods have proven to be the exception. Maintained over the long term, diversification can reduce your portfolio’s volatility, which may improve your chance to reach your investment goals.

“Diversification is more beneficial over a longer time frame,” says Andrew Windmueller, director of institutional portfolio management in Fidelity’s global asset allocation division. “It’s important to think about the value of diversification over your time horizon, not over just a few months.”

Moreover, diversification is far more attractive than the alternative: concentrating a portfolio in a small number of securities. Portfolio concentration increases risk, but may not enhance returns, and could leave you vulnerable to big losses that may be difficult to recover from.

So did the bear market spell the end of diversification? In a word, no. But it did force investors of all ages and asset levels to reassess their understanding of this fundamental investing tenet.

“Recent events have provided investors with the opportunity to reevaluate their financial plans and tolerance for risk,” Macdonald says. “In the future, they can use what they’ve learned to build better-diversified portfolios with allocations that are more consistent with that level of risk.”

1. S&P 500® Index returns were 26.46% from January 1 to December 31, 2009.

2. Fidelity Investments, How to Make Retirement Income Last, Fidelity Viewpoints, 11/7/2009.

3. Standard & Poor’s, “The Seven Rules of Wall Street,” 8/22/2009.

4. The Barclays U.S. Treasury 10-Year Term Bond Index as tracked between month-end March 2000 and month-end October 2002.

5. iMoneyNet, 10/28/09.

6. Fidelity Investments, Does Diversification Still Matter? Viewpoints, 7/1/2009.

7. Standard & Poor’s, “Rotations and Recessions,” 11/26/2007.

8. Russell Investments, 11/30/2009.

9. FTSE NAREIT U.S. Real Estate Index as tracked between month-end March 2000 and October 2002.

10. MSCI Barra, 11/30/2009. Foreign stocks represented by the MSCI EAFE.

CitrinGroup is an investment advisor registered with the Securities and Exchange Commission (notice filing in the States of Michigan and Texas). CitrinGroup does not offer tax or legal advice. Past performance is not a guarantee of future results. Information and/or opinions are those of the authors/presenters and do not necessarily represent that of CitrinGroup and/or its affiliates. Content is prepared without regard to the individual financial circumstances of readers/viewers. Information and/or opinions are not intended as actual investment advice and may not be suitable for everyone. CitrinGroup makes every effort to provide you with useful information, but makes no representation that it is accurate or complete. CitrinGroup has no obligation to tell you when information and/or opinions change.