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Why diversification matters – evidence for investing’s golden rule

The last decade has thrown many challenges, but a simple strategy can help you survive.

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.

  1. See Harry Markowitz’s 1952 thesis, Portfolio Selection, available at www.jstor.org/stable/2975974.
  2. Measured by U.S. stock market returns from Jan 1 to April 30 of each calendar year. U.S. stocks represented by the S&P 500 index from 3/4/57 to 4/30/22 and the IASBBI U.S. Lrg Stock TR USD Index from 7/1/26 to 3/4/57. Past performance is not indicative of future results. Indexes are unmanaged and one cannot invest directly in an index.
  3. U.S. stock market as measured by the S&P Total Market Index. Morningstar (covering period Oct. 1, 2017 to Sept 30, 2022).
  4. As of 9/30/2022, weights for these companies in the highlighted iShares funds are as follows: Zoom Video Communications: ITOT: 0.05%, AOK, AOM, AOR and AOA: 0.0%; Peloton Interactive Inc: ITOT: 0.01%, AOK, AOM, AOR and AOA: 0.0%. For current fund holdings, please click on the tickers under the “Related iShares Funds” section above.

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About the Author
iShares by BlackRock

iShares unlocks opportunity across markets to meet the evolving needs of investors. With more than twenty years of experience, a global line-up of 1400+ exchange traded funds (ETFs) and $3.7 trillion in assets under management as of March 31, 2024, iShares continues to drive progress for the financial industry. iShares funds are powered by the expert portfolio and risk management of BlackRock.