When markets are turbulent, people increasingly focus on risk. It is vital to understand the difference between risk you can control and risk you cannot.
The saying “Don’t put all your eggs in one basket” applies to investments because concentration increases risk. Whether you invest your money yourself or work with a professional, never put all your assets in the same basket—the same kind of stock, bond, mutual fund, or other investment.
In addition to avoiding concentration, diversification is key to improving investment results. Various asset classes, or types of investments, tend to perform differently under certain market conditions. Some perform better, and some perform worse, depending on what is going on with the economy and financial markets. The best investment strategy is to have a diverse portfolio that includes a mixture of stocks, bonds, and international investments.
Diversification across asset classes helps reduce risk; correlation illustrates this benefit. Correlation measures how things, such as investment returns, move in relation to each other. Some asset class returns are more correlated than others. Say you invest in a stock and a bond. If the economy picks up steam, corporate earnings will likely rise, and so will your stock. As the economy picks up steam, however, the Federal Reserve may raise interest rates to keep inflation in check. When the Federal Reserve raises rates, the value of the bond that you hold will decline. Another investor could get a higher interest rate on a new bond issued today because rates are now higher in the market. The decline in the value of your bond is offset to some extent by the increase in the value of your stock. Hence the benefit of diversification.
Not only should you diversify across asset classes, but you should also diversify within asset classes. Invest in different types of stocks and bonds. An easy way to diversify is to invest in companies that are different sizes. Capitalization, or cap, is the market value of all shares of stock outstanding. There are small-cap, mid-cap, and large-cap stocks. In general, small-cap companies have market valuations of less than $3 billion. Large-cap companies are usually market valuations of greater than $15 billion. Midcap companies fall between large and small caps. Changes in the economy and changes in the financial markets can have different impacts on large-cap stocks than on small-cap stocks. Therefore, diversifying across market capitalization ranges lowers the risk of your investment profile.
During periods of financial turmoil, however, correlations across different asset classes rise. Adverse economic factors can have a widespread impact on several asset classes. Therefore, in the short run, it may seem like diversification does not matter. Following the period of disruption, the benefits of diversification will re-emerge. Even during periods of financial distress, differentiate between short-term factors and long-term trends.
