Believe it or not, portfolio diversification has worked
— -- Diversification has turned into a dirty word with many investors saving for retirement.
It looks great on paper. Diversification is the hailed financial theory that says investors can reduce the ups and downs of their portfolio by sprinkling money all over the place in different types of investments, rather than plunking down everything on just household-name U.S. stocks.
Yet, in most cases, diversification hasn't completely shielded investors from the market's intense pain over the past decade. For instance, adding foreign stocks is considered a key part of diversification. Yet, investors have watched in horror as shares of foreign stocks — which tanked along with the U.S. market in 2008 — have continued to suffer amid the European debt crisis.
Investors who take a closer look, though, can see that diversification has done what it's supposed to do. And for investors looking for a prudent way to gear up for the stretch goal of saving for retirement, diversification can still be a big key to success.
"Diversification is like a free lunch, or at least a free hors d'oeuvre," says Ian Ayres, professor of law at Yale University who has studied diversification. "You want to take advantage of it."
Workers looking to put diversification to work for them as they save for retirement must understand:
Diversification did work, even during the downturn.
There's no question it's been a disappointing decade for stock investors. The Standard & Poor's 500 index returned just 1.4% a year on average between January 1, 2001 and Nov.30, 2011, says money management firm IFA.com.
But investors who created a diversified portfolio, containing among other things a 40% weighting in bonds, saw an average annual return of 5.7% during that same period, IFA says. While some asset classes that diversified investors bought have suffered, as a whole, largely due to bonds' strong performance, diversification has evened out the dips.
While investors might be disappointed with a diversified portfolio's returns, they'd be distraught over the return had they not diversified, says Stuart Ritter of T. Rowe Price.
Had investors bought the best stocks of 2007 and held them in the 2008 market downturn, they would be down more than 60%, he says. An investment in just the Standard & Poor's 500 was down a painful, but more palatable, 37% in 2008, he says.
What diversification really is.
Diversification aims to reduce risks of specific types of investments. For instance, if one company in the S&P 500 has a bad quarter, if you're diversified, that won't derail your retirement plan.
But even a diversified stock portfolio can't eliminate what's called "systemic" risk, or the danger that the entire financial system will come under strain, says Weston Wellington at Dimensional Fund Advisors. During a crisis, risk of the entire financial system short-circuiting can hurt even a diversified portfolio. Stated another way: Investors need to understand what diversification is protecting them from, says Dimensional's Gerard O'Reilly. For instance, drivers know car insurance will protect them from financial losses in an auto accident but not if they get sick, he says. Similarly, diversification is a great tool to protect against risks of problems at a particular company or industry, but not if the entire financial system comes under strain.
Diversification can get more powerful over time.
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