Finalize the portfolio construction course with module 5 and learn how diversifying investments can help investors prepare for the long-run.
What does diversifying investments really mean?
Diversification is the technique of spreading investments across several different assets to help minimize risk. This can mean mixing different investment vehicles, industry exposures and geographies of investments.
The purpose of diversification is to minimize against market downturns
The importance of diversifying a portfolio is to help limit exposure to significant losses in the market. In some cases, it can also limit the extent of an upside. In moments where the market is performing well and an investor is not receiving the return they would like, it is important to remember that the purpose of diversification is not to maximize returns but to minimize against downturns.
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This is Luisa.
A lifelong foodie, Luisa loves to create seasonal specials that keep her customers coming back for more.
Just like changing up a menu can lead to higher profits, BlackRock understands that investment flexibility can lead to attractive returns.
One benefit of diversifying across asset classes and geographies is that it can help reduce risk. For instance, the volatility of long-term returns can be decreased by investing across asset classes. Local market declines can also be accommodated for by investing internationally.
When it comes to diversification, finding a balance between risk and returns is key.
Take cash and government bonds. Even though they offer minimum volatility, potential for returns may be limited by prevailing interest rates.
To balance risk and returns, investors might combine less liquid but higher-yielding assets – like real estate – with highly liquid, income-generating assets – like cash.
Equity instruments, on the other hand, are known for high long-term returns. But a portfolio of only equity instruments may entail more risk than a diversified one.
A well-diversified portfolio like this could result in higher returns, generating income in the near-term, as well as capital appreciation down the road.
Lack of diversification could leave an investment portfolio exposed to increased risk and diminished returns.
Like a seasonal menu, a bit of diversity goes a long way toward long-term growth.
Help clients benefit from staying invested for the long-term
While it is important to think long-term when investing, shifts in geopolitical activity and market volatility often leave investors scrambling to take action and sell out of their current positions.>
In these moments, financial professionals can help remind their clients that while returns on investment may feel turbulent in the short-term, staying calm and avoiding impulsive decisions will help charter a better path toward achieving their long-term financial goals. The graphic below helps illustrate the connection between returns and long-term investing.
The longer the investment, the greater likelihood of positive returns
Rolling returns of stocks (1928-2018)
Sources: BlackRock; Bloomberg; Lipper. Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. It is not possible to invest directly in an index.
The below table is another example of how diversification can help improve returns over the long-term. In this illustrative example, the growth of an initial $100,000 investment is compared between the S&P 500 Index and a portfolio diversified across asset classes.
While the S&P 500 receives a higher rate of return when the market is up, the diversified portfolio does not experience as large a negative impact when the market is down. In the long run, the diversified portfolio experiences a better total return.
The more diversified a portfolio, the more likely it is to grow in the long-term
Source: Morningstar as of 12/31/18. Past performance does not guarantee or indicate future results. Diversified Portfolio is represented by 40% S&P 500 Index, 15% MSCI EAFE Index, 5% Russell 2000 Index. 30% Bloomberg Barclays U.S. Aggregate Bond Index, and 10% Bloomberg Barclays U.S. Corporate High Yield Index. Index performance is for illustrative purposes only. You cannot invest directly in the index. Diversification does not guarantee a profit or protect against a loss in a declining market.
What does risk have to do with diversification?
Diversifying investments is a fundamental rule of portfolio management and plays an important role in helping to reduce risk. Diversification is not simply mixing stocks and bonds into a portfolio. It requires understanding how the types of stocks and bonds interact with each other.
The illustrative chart below shows how two portfolios with the same asset allocation (the same percentage allocation of stocks and bonds) can have completely different risk levels.
All three hypothetical portfolios are made up of 50% stocks and 50% bonds but yet, shifting the type of bonds that make up the fixed income allocation significantly impacts the overall risk of the portfolio. For example, increasing or decreasing the percentage of investments allocated to high-yield bonds consequently affects the change in the risk of the portfolio. It is important to be mindful of the impact of these changes so that every portfolio risk is intentional.
Source: Aladdin as of 9/20/18 Equity represented by S&P 500, BBG BarCap US Aggregate Index and IBoxx US High Yield Index. Portfolios shown for illustrative purposes only.
Think differently
Diversification can feel disappointing when returns are not maximized during market upswings but it is important to have a protection mechanism during downturns. Financial professionals should prepare for a downturn rather than worrying about how to avoid one. That means taking the long view when picking investments and always considering the potential for an event to occur, and the impact it could have on a portfolio. Carrying out regular stress tests on a portfolio can help financial professionals prepare for a variety of market events, such as how it might react to rising inflation or widening credit spreads.
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