In a previous post, we wrote about how to beat the market. The solution was that the odds are against you, so you should invest in a well-diversified portfolio of low cost mutual funds and ETFs that track the market. But this raises the question as to why a person’s portfolio returned less than the market.
For instance, you may invest in a portfolio that is made up of 60% stocks and 40% bonds. When you look at the performance of the S&P 500 Index, our proxy for the overall market in this case, you will see it returned close to 14%. You then look at your portfolio and you find it returned a little over 9%. Why is this?
Benefits of Diversification
When it comes to investing, no one can predict what is going to happen in the stock market tomorrow. Because of this, it is important to have portfolio invested in a wide range of asset classes. This guarantees that you will be invested in the best performing asset class each year.
You may read that and say, “I understand, but doesn’t that mean that I will also be invested in the worst performing asset class as well?” The answer to this question is yes, but understand that neither you nor I know what the worst performing asset class is going to be in a given year. As a result, you are better off investing in all asset classes than trying to pick and choose.
For example, if you invest in one single asset class and it declines 50%, you just lost 50% of your investment. But, if you are diversified across many asset classes, the better performing assets will offset the losses in your poor performing asset classes. So, instead of losing 50% of your investment, you might only lose 10%.
The Protection of Diversification
Overall, investing in a well-diversified portfolio protects you on the downside. Put another way, you are reducing the risk of losing a lot of your investment when you diversify your investments. On the other side of the coin, there will be years where certain asset classes return more than what your diversified portfolio does. In these cases, it’s important to remember that your portfolio is designed for long-term success. Successful investing is not a sprint…it’s a marathon.
For more in-depth discussion on diversification, watch this short video about Avoiding The Twin Traps of Fear and Greed.