(Sam Swenson, CFA, CPA)
With stocks in a bear market, bonds offering little more than “less negative” returns, and cryptocurrencies facing a serious reckoning, the first half of 2022 should remind investors that a diversified portfolio will be necessary for years to come. . Overexposure to any particular stock or market sector can lead to crushing portfolio losses, which can have the effect of derailing your investment drive or, worse, jeopardize your retirement.
Let’s take a moment to review why diversification remains vitally important to your investment success.
Diversification: A Quick Review
“Diversifying your portfolio” is another way of saying that you properly spread your money over several different investments. While it’s great to make money investing, not lose money should also be a central consideration. Diversification serves to limit risk.
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Concentrated stock positions, for example, if you had to keep all your money in Apple Stocks: Tie your financial future to the performance of a single company, exposing you to undue risk. Adding more stocks in different industries is likely to give you an adequate return, while also reducing the chance of losing large amounts of money.
Index funds: a simple solution
If you’re placing all-or-nothing stock or cryptocurrency bets, you’re probably risking a lot more than you think. This is why broad-based market-following index funds can make a lot of sense for retail investors.
Index funds track comprehensive indices, such as the S&P 500 or the Russell 2000, which are made up of hundreds of companies from different sectors. Total market funds, such as the Vanguard Total Stock Market Index Fund ETF (NYSEMKT: VTI)tracks even more companies and can be thought of as multiple index funds rolled into one.
Basic index funds can do wonders for investors by grouping stocks into securities that are easy to buy and manage. These funds are also based on diversification, so you won’t have to worry if a company, or even a sector, experiences poor returns over a certain period of time.
Diversification in 2022
As the chart below shows, a portfolio packed with growth stocks (like most tech companies) far underperformed a portfolio of value stocks from the beginning of this year to now:
An investor who made a big bet on growth stocks earlier in the year would have seen their position trimmed by about a third, while a value-only investor would have lost just over 10%.
The middle line, which represents all large-cap stocks (both value and growth), unsurprisingly showed an average result. While losing more than 20% of your money is no joy, one S&P 500 investor avoided a much worse outcome by committing to diversification.
All of this is to say that spreading your money around is important and can help avoid catastrophic outcomes, even if the markets have generally fallen. An investor who put his money into just a few growth stocks could lose well over 32%, a scenario that could have been ruled out with proper asset allocation and planning ahead.
Recommit to your asset allocation
To survive in an environment with low expected returns, you will need to recommit to a diversified portfolio through judicious asset allocation. Put another way, consider allocating a percentage of your money to different asset classes and sticking to your plan over time. Too much money in any asset class can spell disaster, especially in a scenario where nobody knows what will happen next.
The risk of financial ruin can be limited through diversification, which can help limit volatility within your portfolio. Take the time to be deliberate and intentional when it comes to allocating your money. The future will thank you.
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Sam Swenson, CFA, CPA has positions in Vanguard Total Stock Market ETF. The Motley Fool holds positions and recommends Apple and Vanguard Total Stock Market ETFs. The Motley Fool recommends the following options: $120 long calls in March 2023 at Apple and $130 short calls in March 2023 at Apple. The Motley Fool has a disclosure policy.