Why diversification still matters

At Morningstar, we've long been advocates of diversification in investing. A diversified portfolio is less risky than one that's concentrated in one area of the market, because different parts of the portfolio will tend to do well at different times, thus smoothing returns over time.

For example, a portfolio invested entirely in large-cap growth stocks would have gained more than 30% annually from 1995 through 1999 but would have lost around 20% annually from 2000 through 2002. Had that portfolio included 30% in bonds, that bond position would have tempered the portfolio's gains in the late-90s' bull market but also would have reduced its losses in the subsequent stock market crash.

A lot of traditional investing ideas, including the value of diversification, were tested mightily in the brutal bear market of 2008. In the early stages of the current crisis there were still some bright spots, such as emerging-markets and commodity stocks, but by the second half of 2008 there was almost nowhere to hide. Domestic stocks, foreign stocks, commodities, and even bonds posted significant losses, with only Treasury bonds, perceived as one of the only remaining safe havens, gaining ground. It was enough to make some people wonder whether diversification is even worth the bother, if everything is just going to go down.

The second half of 2008 was certainly painful for just about all investors, but it would be a big mistake to extrapolate too much from this very unusual period, as asset-allocation expert Robert Arnott noted in a recent video interview. While diversification generally isn't as effective as usual in a broad-based market crash like that of 2008, it certainly still helps, and last year's anomalous market conditions are not going to last forever.

Diversifying by Asset Class

For example, consider the most fundamental type of diversification, building a portfolio with exposure to asset classes such as stocks, bonds, and cash (sometimes with other asset types such as gold or real estate thrown in). This type of diversification is the most important part of bringing a portfolio in line with a given investor's risk tolerance and time horizon. In general, the greater a portfolio's stock weighting, the greater the risk; adding bonds or cash will tend to make it less prone to extremes on both the upside and the downside, as in the example we saw above. The closer you are to needing the money, the more bonds and cash you should have.

Now, it's true that many bonds have lost ground along with stocks over the past year, and some bond funds have blown up in spectacular fashion. Even so, investors who held some bonds last year along with stocks lost significantly less than those who were 100% in stocks.

In the current market environment, it might be tempting to go all the way and put your portfolio entirely in cash or Treasury bonds. The problem is that stocks are apt to improve eventually, and if you're positioned ultraconservatively you're likely to miss out on a lot of gains when that happens. If all you're concerned about is preserving capital, that might be OK, but most investors--even many retirees--want to strike a middle ground between capital preservation and potential gains. Indeed, there are already signs that things are shifting.

Sector and Geographical Diversification

Asset-class diversification is the key step in building an appropriate portfolio, but it's also important to consider diversification within asset classes, such as whether your stock investments are diversified across sectors.

The 2008 market environment appeared to test the notion that sector diversification matters: While it appeared that certain sectors, such as energy and basic materials, were bucking the market's downward trend in the first half of the year, collapsing commodity prices in the second half caused those stocks to plunge. There was seemingly no place to hide.

However, as with asset classes, it would be a mistake to conclude from all this that sector diversification doesn't matter. For one thing, some sectors have lost significantly less than others in the current downturn; the average health-care stock has lost about 13% over the past year, while the average financial stock has lost almost 40%. That doesn't mean that you should sell all your financial stocks and load up on health care, though; many funds that tried to make such outsized sector bets over the past year got burned. The point is that the various sectors still don't move in tandem, but it's virtually impossible to predict which will do best going forward, so it's generally a good idea to spread things out a bit.

It's a similar story with geographical diversification. In the early stages of the current downturn, emerging markets such as China and India continued rising even as the US market was sputtering, leading to a lot of talk about how those markets were "decoupling" from the US economy. However, everything went down in 2008, especially in the second half.

That was certainly an ugly period for markets all over the world, but it was very unusual historically; markets have already started diverging again, and as with asset classes, they're sometimes doing so in unexpected ways. The worst-performing foreign-stock category in 2008, Latin America stock, is by far the best performer so far in 2009, while the Japan-stock category, which held up well last year, has been among this year's worst performers. Diversification may not be the key reason to hold foreign stocks in your portfolio anymore--owning great companies domiciled overseas is--but geographic diversification is another step that can smooth out your portfolio's returns from year to year.

What We Do Know

Last year's market collapse, while painful in almost unprecedented ways, did not change the fundamental importance of diversifying your portfolio. It's true that diversification becomes temporarily less important in times of market panic like we experienced last fall, but those times don't last forever. Once markets recover, diversification arguably becomes more important than ever. It's very difficult to predict which areas of the market will lead a recovery, so betting heavily for (or against) one of them is risky business.

Of course, most investors are willing to take some risk, but it's important to be aware of how much you're willing to tolerate, and whether your portfolio is diversified appropriately for that level of risk.