The Benefits, Drawbacks, and Reality of Diversification

Diversification means spreading your investment portfolio across different types of assets, so you are not overly exposed to one risk. “Don’t put your all your eggs in one basket” is the phrase that comes to mind. However, it is not just owning a lot of different investments, but it is owning investments that tend to behave differently.

The chart below shows an example of the annual returns of different asset classes over time. We often refer to this chart as the “quilt chart.” The chart is organized by showing the relative annual performance of each asset class during the year. During many of the years shown, some asset classes zig while others zag, which is the whole idea.

Benefits:

Although diversification doesn’t guarantee you will make money, it does help reduce risk. Instead of betting on one market each year to outperform, you spread your risk so that a bad “bet” doesn’t sink your entire portfolio. By doing so, it can smooth out returns over time. It may not feel exciting, but it does help investors stay invested, especially during volatile times.

Drawbacks:

Every year there will be one market that outperforms another, and some that lag by quite a large margin. The problem is knowing which one will be the future winner. This is the emotional cost of diversification, as the portfolio can feel like you are missing out or you are holding an asset class that has not done well.

Reality:

Diversification is not about maximizing returns in a single year. It is about increasing your odds of meeting your goals over time. It is a long-term strategy built on the idea that no one knows what the future holds. Owning a broad mix of assets can help you stay invested, which can be key.