Why diversification matters – evidence for investing’s golden rule
Historians, economists, and social scientists will long study the last decade for lessons on human behaviour. For the average investor, though, a key lesson already stands out: There’s wisdom in diversification.
Diversification is the practice of not holding all your eggs in one basket, thereby owning a mix of stocks with different business activities, as well as other investments like bonds. This cornerstone investment principle was born in the 1950s, helped spur the advent of index mutual funds in the 1970s, then drove the rise of index-tracking exchange traded funds (ETFs) starting in the 1990s.1
Index funds give all investors simple and low-cost access to diversified investment strategies and, in recent decades, helped individuals move from owning individual stocks, which bring with them unique and concentrated risks, to increasingly global strategies spanning stocks, bonds and more.
So, what has diversification and index funds done for investors recently?
Spreading the risk around through diversification
Over the last few years investors have been whipsawed by unprecedented market events. Steep declines tied to COVID-19 were followed by a sharp rebound in U.S. stocks, only to give way to losses driven by inflation and slowing growth. In fact, the first four months of 2022 marked the 3rd worst start to a year for U.S. stocks since 1926.2
Despite this wild ride, over the last five years, patient investors have been rewarded as U.S. stock indexes have risen over 50%.3 But, while the market has gone up, not all stocks have been a good investment. 48% of U.S. stocks declined during that same period, meaning investors picking stocks from the broad market had a greater than one out of three chance of selecting a loser. And many of the stocks that fell, fell hard. Among the U.S. stocks that declined over the last five years, the average drop was 51%.4 In other words, half of stocks lost half their value. If buying single stocks, it could have been easy to be a loser in a winning market.
Keeping an eye on the long-term
The point is that successfully timing the market with individual securities or even whole sectors — buying and selling at just the right times — is difficult even for the most experienced investor. In fact, chasing the latest high-flying investment can cause harm to a portfolio’s long-term returns. Some index ETFs can hold the whole market, a strategy which can help investors avoid sharp declines of a few stocks or sectors.
Summing it up
Diversification helps investors to navigate fast-changing markets and stay the course to pursue their financial goals. The past few years have offered a masterclass in how diversification through index-based ETFs could have helped the average investor avoid losing in a winning, albeit volatile, market.