While potential returns should compensate you for risk, there are some risks that you will not be compensated for, and therefore they should be avoided.
If you invest in a single security, your return will depend solely on that security; if that security flops, your entire return will be severely affected. Clearly, held by itself, the single security is highly risky.
If you add nine other unrelated securities to that single security portfolio, the possible outcome changes—if that security flops, your entire return won't be as badly hurt. By diversifying your investments, you have substantially reduced the risk of the single security. However, that security's return will be the same whether held in isolation or in a portfolio.
Lower risk, similar return, better investment.
Diversification substantially reduces your risk with little impact on potential returns. The key involves investing in categories or securities that are dissimilar: Their returns are affected by different factors and they face different kinds of risks.
Diversification should occur at all levels of investing. Diversification among the major asset categories—stocks, fixed-income and money market investments—can help reduce market risk, inflation risk and liquidity risk, since these categories are affected by different market and economic factors.
Diversification within the major asset categories—for instance, among the various kinds of stocks (international or domestic, for instance) or fixed-income products—can help further reduce market and inflation risk. And as shown in the 10-security portfolio, diversification among individual securities helps reduce business risk.
The importance of diversification can be seen by restating it in the negative: If you don't diversify, you are taking on a considerable risk for which you will not be compensated.
Time Diversification
There is one other type of diversification that is extremely important yet often overlooked—time diversification, remaining invested over different market cycles.
Time diversification helps reduce the risk that you may enter or leave a particular investment or category at a bad time in the economic cycle. It has much more of an impact on investments that have a high degree of volatility, such as stocks, where prices can fluctuate over the short term. Longer time periods smooth those fluctuations. Conversely, if an investor cannot remain invested in a volatile investment over relatively long time periods, those investments should be avoided. Time diversification is less important for relatively stable investments, such as certificates of deposit, money market funds and short-term bonds.
The best example of the benefits of time diversification is in the stock market. The year 2008 saw the market drop fully 37.0%. However, in the following years the market recovered some ground. Longer time periods illustrate the point further. For instance, over the 10-year period from 2006 through 2015, which includes the 2007-2009 bear market, you would have earned an average 7.3% annually if you had remained fully invested in the market, with actual annual returns varying between -37.0% in 2008 and 32.4% in 2013.
Time diversification also comes into play when investing or withdrawing large sums of money. In general, it is better to do so gradually over time, rather than all at once, to reduce risk.
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