How does diversification reduce risk?

Do you know that old saying, “don’t put all your eggs in one basket”? It’s the same when it comes to investing. Putting your entire nest egg into any single company could be a recipe for losing everything. The answer to a sound investment strategy is to diversify. But, what is diversification and does it really matter?

Diversification means you are choosing to invest in things that are uncorrelated with each other. In other words, if one particular stock or sector increases, the other stock is less likely to do the same thing. The easiest example of this is the relationship between stocks and bonds. Historically, bond funds performance is inversely related to stock funds, meaning that as the value of bond funds increase, typically stock funds will decrease. The same is true in reverse.

Investing too heavily in one particular asset class can overexpose you to risk. Conversely, spreading your investments over a number of different asset classes can significantly reduce your risk. And if you are heading into retirement, reducing risk is something you’re likely wanting to do.

Remember 2008? Most people’s 401(k) values dropped by as much as 50%. Imagine you are retiring in two years and your nest egg loses half its value. Your portfolio would have to see gains by as much as 100% in two years just to get back to your starting point.

Take a look at this table showcasing different asset classes and their performance over 2009-2018:

Follow the “Commodities” sector through the years. In 2009 and 2010 it performed well, and then in 2014 it lost by -33.1%. Since there is no way to predict how the market will perform, diversifying across a number of industries or asset classes can help reduce your risk. It can also reduce volatility, and even increase your opportunities to maximize gains over time.

Is there such a thing as being too diversified?

Technically, yes, and spreading your risk really far could stall your potential gains. This is where strategic allocations come in. We use a method called Time-Segmented Investing to reduce volatility, and spread the risk out in time segmented needs we call “buckets”. Each bucket is assigned a time horizon, and we invest accordingly to match your risk levels to the time horizon of that bucket.

For near term needs, we invest very conservatively. And for longer-term needs, we invest more aggressively. All of this is mapped to your 3 levels of risk and every other piece of your financial picture is taken into account as well.

If you want to learn that your investments are well diversified and match your risk levels, start a conversation with an advisor today and ask to take our free Riskalyze assessment.

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“Understanding the Schwab Asset Class Quilt® | Charles ….” 30 Mar. 2018, https://www.schwab.com/resource-center/insights/content/understanding-schwab-asset-class-quilt. Accessed 17 Sep. 2019.