The Importance of a Diversified Portfolio

A diversified portfolio consisting of many different types of securities can help reduce the risk to your wealth when a single stock drops in value. It only makes sense -- if you held all your assets in one stock and it fell by 50 percent, you would lose half of your asset value. If you owned 50 stocks and one of the stocks dropped 50 percent, you would lose just 1 percent of your value. That’s the effect of diversification. However, remember this strategy does not guarantee a profit, or protect against loss, it just aids in reducing the risk to your wealth.

In the world of investing, risk is seen as the unpredictability of the future value of an investment. Return is the increase or decrease in the value of the investment. Studies have established that there is a tradeoff between risk and return. When taking on higher risk, investors will demand greater potential returns to compensate for the risk. Markets tend to price investments to reflect expectations of return and perceived risk. This chart illustrates this concept:

Risk and return are balanced out through diversification. The value of stocks and bonds often exhibit an inverse relationship. Smaller-company (or small-cap) stocks and larger-company (large-cap) stocks behave differently from each other. Similarly, stocks chosen using a value approach differ in performance from growth stocks.  

By combining small-, midsize-, and large-company stocks with growth and value styles of investing, as well as foreign stocks, you can produce a portfolio with different risks for the level of return you desire. Alternatively, you can seek a higher expected return if you can tolerate a higher level of risk.

Another reason that diversification is important is because it is impossible to predict the market. For example, this chart illustrates the various foreign sectors and their return on investment for the years 2002- 2007. As you can see, there is no discernible pattern from year to year:

Similarly, this chart shows the annual return on investment for 16 major asset classes over a 10 year period.  Each year’s best performer is at the top, the worst is at the bottom. As you can see, there is also no pattern here. Since it is impossible to predict future winners merely by looking at their past performance, it is best to invest across many asset classes and diversify your portfolio.