Why it is wise to diversify

by Ike Trotter

Published: February 22,2013

Tags: Ike Trotter, personal finance

Money in handMost all of us know of friends and neighbors who try and “chase returns” with the stock market today. Throw in to that mix day traders and others who are constantly hunting for the next hot stock, endlessly refreshing browser windows in search for breaking news and tips from assorted gurus.

Is that the path to making money in stocks? Maybe. Then again… maybe not. Many, however, eventually tire of the stress involved, and come to regret the emotional decisions that invite potential financial losses and stifle the potential for long-term gains.

Understand — we all want a terrific returns, but managing risks as well as expectations is part of the game, as well. That is why diversification is so important. There are two great reasons to invest across a range of asset classes, even when some are clearly outperforming others.

No. 1: You have the potential to capture gains in different market climates. If you allocate your invested assets across the breadth of asset classes, you will at least have some percentage of your portfolio assigned to the market’s best-performing sectors on any given trading day. If your portfolio is too heavily weighted in one asset class, or in one stock, its return can be too heavily weighed on its performance.

So is diversification just a synonym for playing not to lose? No. It isn’t about timidity, but wisdom. While thoughtful diversification doesn’t let you “put it all on black” when shares in a particular sector or asset class soar, it guards against the associated risk of doing so. This leads directly to reason number two:

No. 2: You are in a position to suffer less financial pain if stocks tank. If you have a lot of money in growth stocks and aggressive growth funds (and some people do), what happens to your portfolio in a correction or a bear market? You’ve got a bunch of losers on your hands. And tax loss harvesting can ease the pain only so much.

So, properly utilized, diversification gives your portfolio a kind of “buffer” against market volatility and drawdowns. Without it, your exposure to risk is magnified.

» What impact can diversification have on your return? Let’s look at the “lost decade” for stocks, or more specifically, the S&P 500 performance during the 2000s. As a USA Today article notes, the S&P’s annual return was averaging only +1.4 percent between Jan. 1, 2001 and Nov. 30, 2011. Yet an investor with a diversified portfolio featuring a 40 percent weighting in bonds would have realized a +5.7 percent average annual return during that stretch.

If a 5.7 percent annual gain doesn’t sound that hot, consider the alternatives. USA Today noted that an investor who bought the hottest stocks of 2007 would have lost more than 60 percent on his or her investment in the ‘08 market crash. Investments tied to the S&P 500, however, sank 37 percent in the same time frame.1

»Asset management styles can also influence portfolio performance. Passive asset management and active (or tactical) asset management both have their virtues. In the wake of the stock market collapse of late 2008, many investors lost faith in passive asset management, but it still has fans. Other investors see merit in a style that is more responsive to shifting conditions on Wall Street, one that fine-tunes asset allocations in light of current valuation and economic factors with an eye toward exploiting the parts of market that are really performing well. The downside to active portfolio management is the cost; it can prove more expensive for the investor than traditional portfolio management.

»Believe the cliché: don’t put all your eggs in one basket. Wall Street is hardly uneventful and the behavior of the market sometimes leaves even the pros scratching their heads. While we can’t predict how the market will perform; we can properly diversify to handle the challenges of when our money goes up… and, just as importantly, when it goes down.

This Month’s Parting Shot: While Washington, D.C., continues to search for ways to raise taxes, the action is hot and heavy in several states to either reduce or eliminate state income taxes. News media reports have it that many high income wage earners in New York and California are scrambling to pack up their bags and move to tax friendly states like Florida and Texas which have no income tax. Say what you want about paying your fair share; red blooded American taxpayers will do whatever possible to keep from forking out any more taxes than necessary.

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