Diversification is a sound investment principle. I would say that every Minnesota investor at one time or another has heard or read something about the benefits of a diversified investment account.
“Don’t put all your eggs in one basket” is about all you need to remember about diversification.
The best use of diversification is to spread your money around into different types of investments in order to reduce your risk. This investment management strategy is easily accomplished today due to the wide variety of investment options available to every size of investor in every type of investment account.
The important thing to remember is that diversification does not eliminate risk.
International stocks were once hailed as a way to diversify away from exposure to the U.S. economy. Several years ago, the main international stock markets were not closely related to the direction of either the U.S. economy or the U.S. stock markets. Today, that is no longer true.
International stock markets are all interrelated; they rise and fall together most times. That fact was clearly demonstrated during the most recent stock market crash in 2008-2009.
The lesson is that diversification might help smooth out routine stock market fluctuations, but under extreme conditions your stock market risk level is likely to rise and fall at the same time regardless of your diversification efforts.
Most financial advisors make the case for individual investors to diversify their investments and to place them on auto-pilot. The thinking is that if your investment assets are properly diversified, your long-term investment returns will be acceptable over the long term.
From February 1, 2000 to February 1, 2013, the total investment return of the S&P 500 was 7.31%. If you would have placed the same amount of money in a money market account, your investment return would have been close to 30% over the same time period.
Neither of those investment returns over a period of 13 years is acceptable. Food,gas, rent, and college tuition have all risen much more than 30% over the last 13 years.
Diversification of your investment assets is not the only investment management strategy solution. Managing the stock market risk on your investments is a lot more important than diversification.