Remember Diversification?

September 26, 2012

It’s not a new idea, the principle that holding a diversified portfolio can help you manage short-term market volatility by providing steadier performance over time. And it’s still a fundamental portfolio construction concept, even after the unusual market conditions of late 2008 and the recession that’s followed. But you may not have given it much thought (or practice) since then — and there are a few new things you should know.

Diversification vs. market downturn. It helps to start with a renewed understanding of the concept. “The theory holds that if a portfolio includes a wide range of investments that tend to perform out of sync with one another, then when some investments decline, others should post smaller declines, and some might even generate gains,” explains Scott Wren, Senior Equity Strategist at Wells Fargo Advisors.

The last market downturn caused many investors to re-examine the conventional wisdom, however. The financial crisis caused nearly all assets — including stocks in every sector of the economy, developed and emerging foreign markets, commodities, real estate, and even corporate and municipal bonds — to slide in unison during late 2008 and early 2009. As a result, even thoroughly diversified investment portfolios were likely to have suffered negative returns.

Investor skepticism about diversification is understandable following this tumultuous period. “Portfolio diversification couldn’t smooth returns as effectively in 2008 because almost all asset classes moved in the same direction — down,” Wren says. With the exception of cash and Treasury bonds, Wren adds, investors had no place to hide.

Still, Wren believes diversification remains as important as ever. “Diversification might not have helped much during the bear market, but it didn’t hurt either,” says Wren. “And it worked before 2008. Now that we are beyond the worst of the economic downturn, it’s working well again.”

Simple concept, complex execution. Wren describes the almost across-the-board declines in 2008 as the exception, not the rule. He points out that during most market downturns, some asset classes produce stable or positive returns.

Moreover, diversification increases the likelihood of benefiting from the top-performing assets during a given period. “It would be great if we could know which asset class was going to perform best in the coming years,” says Wren. “But it’s not likely anyone could consistently predict that, which is when spreading assets across several investments can make a difference.”

The most basic type of diversification involves finding a balance between two asset classes: equity and fixed income. But it goes much deeper. “We break down the domestic equity component of a portfolio into large-, mid- and small-cap stocks, and we break those categories into growth and value styles,” says Wren. “In fixed income, we diversify among securities of various maturity lengths and credit quality.”

Beyond these distinctions, investors can also diversify internationally and among economic sectors. Some individuals might choose to augment their asset allocations with investments such as commodities and real estate. Determining which of these asset classes to include in a portfolio — and the amount of capital to allocate to each, depending on personal goals, risk tolerance and time horizons — is the art and science of effective diversification.

Diversifying after the downturn.  Wren doesn’t believe the lessons of the economic downturn call for fundamental changes to diversification strategies. That’s not to say that your asset allocation should be static, however; he suggests regularly revisiting your allocations with your Financial Advisor and adjusting as needed to reflect both your evolving investment goals and broader economic conditions.

It’s important to remember that diversification is a strategy designed to work over time, rather than a way to time the market. “It’s about reducing the tendency of a portfolio to make extreme moves, whether down or up,” Wren says. “That way, you can focus on making progress toward your long-term goals instead of day-to-day market swings.”

Diversification does not guarantee profit or protect against loss in declining markets.

Government bonds and treasury bills, unlike stocks, are guaranteed as to payment of principal and interest by the U.S. Government if held to maturity.

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This article was written by Wells Fargo Advisors and provided courtesy of Robert Sek.

Wells Fargo Advisors, LLC, Member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company.

©2012 Wells Fargo Advisors, LLC.  All rights reserved. 0812-0580 [87572-v1] 08/12