Diversification across a number of assets classes can reduce a portfolio’s volatility and enable investors to stick with a long term investment strategy.
While many people have heard that diversification is a critical part of investing, many people still don’t understand how important this is for long term investment success. To illustrate this, I will describe the importance of diversification concept for a hypothetical person who invested in an American Funds 2030 Target Date fund and is looking to retire in 10 years.
Look at the table below. 100% stock investments are represented with a red color. On March 27, 2020 a 100% equity index fund of the S&P 500 (red) had declined -24.7% from its high on 2/19/2020. However, for an individual holding a diversified pool of assets, here represented with the American Fund Target Date 2030 (blue), their holdings declined -15.8%.
While the American Fund Target Date 2030 still suffered a decline, it is not nearly as bad as the 100% equity holdings. This is because the diversified fund likely had exposure to high quality bonds, such as long-term US Government Treasury bonds (show on the table in green), which appreciated by +15.4% during this same time period.
Diversification across a wide spectrum of a similar asset class, such as 100% equity funds, is not true diversification. All of these holdings were down greater than -20% over this selected time frame.
This example should illustrate the importance of diversification to a person’s long-term investment strategy. In this case, the pre-retiree is likely more apt to stick with their long term investment strategy, as it has held up relatively well in a very difficult investment environment. Therefore, the key to diversification is holding different types of asset classes – stocks, bonds, and cash. Target date funds are an excellent way to have a professional portfolio manager prudently do this for you. Please note that even well-diversified funds will have different performance statistics depending on the specific asset mix, active manager performance and other security specific issues.
Also note that diversification does not eliminate investment risk. If investment fundamentals deteriorate greater than current expectations, it is very possible that financial assets will decline in value as well.
If you are unclear about your investment portfolio composition and how it is suiting you in this uncertain capital market environment, give me a call and let’s chat. I specialize in personal wealth management and helping business owners select 401ks for Seattle small businesses.