Diversification: The "Free Lunch" of Portfolio Building
It’s also known as “the only free lunch in investing” because, when done properly, diversification has the potential to reduce your overall risk while sacrificing little – if any – long-term return.
Different investments face different threats: Stocks face bankruptcy risk, bonds face interest rate risk, agricultural commodities face weather risk, and so on. Any one of those risks can sink an overly concentrated portfolio. But by spreading your portfolio over many unrelated assets and asset classes, you limit the damage any one risk can do.
The quilt chart below brilliantly visualizes this dynamic. Year-in and year-out, different asset classes and investment styles shine as the market reacts to ever-changing conditions. As you can see, there have been no consistent winners – the top asset class in 2021, Large Cap Growth, was the worst-performing asset class in 2022. The fact of the matter is, the financial market’s tendency to revert to the mean often turns last year’s winners into next year’s losers.
Rolling Asset Class Returns, 2013-2022
Source: FactSet; Standard & Poor’s. As of December 31, 2022. Annualized return, volatility (as measured by standard deviation) and Risk-Adj. Return (as measured by Sharpe ratio) are calculated as of the most recent quarterend. Large Growth is represented by Russell 1000® Growth Index. Large Value is represented by Russell 1000® Value Index. Mid Cap is represented by Russell Midcap® Index. Small Cap is represented by Russell 2000® Index. Taxable bonds is represented by BBgBarc. Intermediate Govt/Credit Bond Index. Municipal bonds is represented by the BBgBarc Municipal Index. International is represented by The MSCI EAFE Index. Cash is represented by FTSE 3 month T-bills. Satellite is an equally-weighted return of the following indices, rebalanced monthly: ICE BofAML US High Yield (High Yield) DJ US Select REIT (Real Estate), Bloomberg Commodity (Commodities), and MSCI Emerging Markets (Emerging Markets). Indices are unmanaged and are used to measure and report performance of various sectors of the market. Past performance is no guarantee of future results and diversification does not ensure against loss. Direct investment in indices is not available. The Russell Indices are a trademark of the Frank Russell Company. Russell® is a trademark of the Frank Russell Company.
Proper diversification can also keep a portfolio from skewing too far in favor of one style, asset class, or geography – even if unintentionally. Continuing the example above, Large Cap Growth was a dominant outperformer for the decade ending in 2021, only to see a steep reversal last year. Without regularly rebalancing, a portfolio would have been overexposed to Large Cap Growth entering 2022 and felt the brunt of the selloff even more severely. Diversification requires regular upkeep to enjoy the benefits.
In the end, the world is full of uncertainties and risks – investment-specific, country-specific, asset class-specific, etc. We cannot escape these uncertainties nor can we predict the future, but through proper diversification (and, again, regular rebalancing), we can spread out our exposure and limit the damage done by any single risk at a given time. While it does not guarantee against loss, it is one of the best tools in an investor’s toolkit to building robust, resilient portfolios and reach long-term financial goals.
Editor’s Note: This article was originally published August 2020 and was updated February 2023 with more current information.
The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.