Diversification is one of the most important investing rules all investors should know. The old cliché “don’t put all your eggs in one basket” is correct. You really shouldn’t do it. Keep reading to learn about the importance of diversifying your investments.
What Is Diversification?
Diversification is the act of allocating your capital in a way that reduces your exposure to any one particular asset or risk. Use the Callan Periodic Table of Investment Returns to follow along.
Callan Periodic Table of Investment Returns
The Callan Periodic Table of Investment Returns demonstrates that the market can function and flow in many ways from year to year. The Callan Periodic Table of Investment Returns ranks each category box from highest to lowest return over each calendar year. For instance, 2018 was a very low return year across almost all boxes. First place goes to Cash Equivalent, +1.87%; next is U.S. Bonds, +0.01%. In a year like 2018 of negative stock markets, the number-one return comes from the safest and most stable category. Meanwhile, Emerging Markets, -14.58%; Non-U.S. Stocks, -14.09%; Small Companies, -11.01%. Large U.S. Companies were -4.38% – not great, but not -15%.
While there may not seem to be much rhyme or reason to the stock market’s wild swings between winners and losers, there’s a clear case to be made that diversification is the best strategy over the long haul. Dissecting the stock market into categories and then tracking those dissected categories as a whole and individual relative to each other can help you learn a lot about how the markets tick over time. While the stock market can be broken into many different categories, for this example we will use Asset Classes (stocks vs bonds), Capitalization (large vs small), and Equity Markets (U.S. vs non-U.S.). Let’s take a look.
Stock Market Changes
2017 was a completely different market environment. It was a year of optimism (refer to Callan Periodic Table of Investment Returns). For example:
- Emerging Markets was +37.28%
- Non-U.S. Stocks was +24.21%
- Large U.S. Companies was +21.83%
- Small U.S. Companies was +14.65%
Meanwhile, Cash Equivalent was last place with +0.86%. See how the complete opposite can happen from one year to the next? The stock market can change direction on a whim – that’s why diversification is so important.
Why Is Diversification Important?
Want more stability? Then diversification is key. Investors should remember this fact about diversification – it means you’ll own some losers for periods, but as the market gyrates round and round, the overall return on your investments is more stable than if you try to pick the right “horse” each year.