Diversification is Key

We believe that holding a broadly diversified portfolio representing many different asset classes reduces overall risk and allows for favorable performance in a variety of market conditions. Diversification allows investors to capture the return from the whole market instead of taking a risk on specific sectors, individual securities or market predictions.  Contrary to what some believe, simply owning an S&P 500 index fund or having “a lot of stuff” in a portfolio does not necessarily indicate diversification.

In order to understand real diversification, we need to take a step back.

Capital markets are comprised of many different kinds of securities, including stocks, bonds and mutual funds both domestic and international. An asset class is defined as a group of securities (i.e. stocks or bonds) that share similar characteristics. There are numerous asset classes, all with different price movements. Because asset classes have different price movements, investors benefit by structuring a portfolio that takes advantage of as many of those classes as possible. By focusing on the portfolio as a whole instead of analyzing each part independently, investors realize that a diversified portfolio adds up to more than the sum of its components.

The chart below shows three sets of quarterly annualized returns from January, 1970 through March, 2010. Compare the return of the Diversified Portfolio on the right with its two components on the left.

Even though the MSCI Japanese Index had lower annualized returns than the S&P 500 Index, when combined they produced a portfolio with a higher rate of return and lower volatility than they did individually. That's how diversification really works.

Next: Costs & Taxes Matter