Talk to any financial expert and they’ll tell you that the key to successful investing boils down to having a diversified portfolio. And you agree with them, you think. You understand the concept of never putting all your eggs in one basket. And it makes sense to you to spread your assets around in order to reduce your risk. But have you ever truly analyzed why, exactly, investment diversification is the key?
“Diversification is so important because it limits your exposure and prevents you from being wiped out,” says Anthony Perez, a financial advisor at Ameriprise Financial. “And besides, my crystal ball doesn’t work.”
Perez explains further that because he doesn’t know what is going to be the best performing asset next month, next year or over the course of ten years, the wise thing to do is to rely on test after test that has shown that if he puts a client in a diversified portfolio that allocates that portfolio based on the client’s risk tolerance, that over the course of time, over the long term, the client will actually be in a better position financially. They will have weathered the storm.
Expert after expert reiterates the concept of making investments with the thought in mind that no one knows exactly what the market is going to do and, because of this, diversification is the answer.
“It’s impossible for people to predict the market, so that’s why you have to spread your risks around,” advises Mary Coughlin, principle at Barnegat Bay Capital Management, adding that you need to ask yourself how much risk you want to take and then diversify from there.
With diversification, you can find potential returns in likely and unlikely places: mutual funds, bonds, cash, and varied sectors like utilities, technology, banking, industrials. The key is to know where you want exposure in different markets.
And if you look at the market as a whole and see what stocks are going up or going down, generally you’ll find it’s a handful of days that drive the return for the year. Similarly, when you look at any given year and think what were the industries or the companies that really did the best, it’s usually a handful. No one has any statistical certainty in advance which are the great industries or which are the great companies.
Manisha Thakor, founder and CEO of Money Zen Wealth Management, says, “Look at it this way: The purpose of diversification is to make sure you’ve got your finger in all the different buckets so that when the tide rises, your boat's going up.”
Thakor also emphasizes the fact that no one individual investor can get a handle on truly analyzing the market’s behavior. Unless you want to spend your time exclusively and intensely analyzing individual stocks — even then, there is still ultimately no way to be certain.
Using an analogy many people can relate to, Thakor says that the benefit of a diversified portfolio is like the benefit of eating a smoothie on the go. You’re rushed; you don’t have time to cook. You could grab a handful of chocolate chip cookies or you could throw some fruits and veggies in a blender and have a bunch of different things that are healthy so there will be much greater odds that you’re getting the nutritional value that you need.
And when you think about what kinds of “different things” that go in your portfolio, think variety. Think about big and small companies. Think about companies not all in the United States — have some that are international. Have companies that aren’t all developed but are emerging. Have a wide range of ways to slice things.
“That’s why diversification is so powerful,” surmises Thakor. “You get bits and pieces of everything.”