June 24th, 2015 | David Simpson

Why we diversify investments in your portfolio

Diversification is the basic building block for an investment portfolio and one of the ways we can reduce risk in the portfolio by not keepingĀ all of your eggs in one basket. Diversification is not a new concept; the first reference in recorded history was over 3,000 years ago in the Old Testament. How you diversify your portfolio has changed over time but the reason has remained the same–to reduce risk. Diversification is not a get-rich quick scheme but to make sure that your portfolio does not experience too much risk. This does not prevent losing money but reduces the potential for loss compared to a non-diversified portfolio.

In any given year, it could look like diversification is a hard argument to make. In 1999, the Technology Sector was the place to be but the 2000 correction reversed many of the gains. In 2014, the S&P 500 (representing US Large Stocks) was up over 13% while major international stock indices were down from 2% to over 7% (depending on the index). So far in 2015, as of 5/31/2015, the S&P 500 is up 3.23% but the same international indices are up between 5.69% and 7.39% (Morningstar).

Diversification is important to make sure that you do not invest based on emotions but instead invest based on your long-term plan and your overall comfort level with risk. Diversification helps to reduce risk but does not eliminate it. When markets are very rough, such as 2008, diversification does not help as much compared to normal markets. In normal markets, investments move up and down at different times. When markets get very rough and stormy, more of the investments move in similar patterns.

Many have tried to time investments but few have done it successfully. Some investors have made significant wealth by not diversifying broadly (such as Warren Buffett) but it is an entirely different matter when you are hands-on and running the company. According to a study by Roger Ibbotson (Finance professor at Yale University), 91.5% of portfolio return is explained by the mix of investments.

It is also important to make sure that you select a mix you are comfortable with longer term so that you do not react by selling out at market bottoms or buying at market tops due to the fear and mania of the crowds. Per the same Ibbotson study, market timing only accounted for 2% of the return. How much you put in each category (or basket) is the most important decision. We like to make sure that each investment basket has some eggs and that the eggs are good quality (investments within a class).

Image: Forbes.com