Why Diversification Matters Now

An aging bull market and increased volatility make diversification an important investment consideration. 

bull figurine and market charts

In the 1967 movie "The Graduate," a family friend offers young Benjamin Braddock advice: "Plastics . . . There's a great future in plastics."

That may or may not have been good career advice in the late '60s. But for investors, focusing on a single industry sector or asset class has generally been a bad idea. In today's market — with the aging of the bull market and its increasing volatility — we believe diversification is an especially important consideration.

Where we are now

The current bull market, now running for nine years, doesn't show any signs of ending in the near term, says Chris Haverland, Senior Vice President – Global Asset Allocation Strategist at Wells Fargo Investment Institute. But that doesn't mean it will go up and in a straight line. In fact, the ups and downs of the markets are likely to continue to generate headlines as we move through the year.

"Volatility likely will remain elevated in the near term," Haverland says.

We believe investors should consider these two strategies as they strive to meet their financial goals:

  1. Diversify. Diversification remains an effective strategy that can help smooth out the jagged ups and downs of the market. Spreading investments across multiple assets classes, such as stocks and bonds, and across different sectors of the economy gives you the potential to profit from growth in different segments of the financial markets.
  2. Rebalance. Getting into the habit of reviewing your portfolio on a regular basis, such as twice a year, can help you identify opportunities to rebalance. When there are big swings in the market or when something significant has changed or you have experienced a major life event, such as a career change, a change in marital status, or the birth of a child, it should be a signal to check your portfolio and rebalance if needed. That typically means selling assets that have grown to represent too big a share of the overall portfolio and buying others that are underrepresented.

"At Wells Fargo Investment Institute, we believe that it makes sense to buy equities on meaningful dips and rebalance portfolios regularly to take advantage of asset-class prices that have gone on sale," Haverland says.

"Volatility likely will remain elevated in the near term." — Chris Haverland, Senior Vice President – Global Asset Allocation Strategist, Wells Fargo Investment Institute

What lies ahead: Diversification and recession protection

Haverland and his colleagues at Wells Fargo Investment Institute aren't expecting a recession this year, but the current cycle of economic growth is already one of the longest on record. No one can say for certain when it will end.

Diversification is one way to help manage risk during a market downturn that will accompany a recession. To get the full benefits, however, your portfolio needs to be diversified before any such downturn.

"A diversified portfolio's most important benefit may be that it can help mitigate the effects of unanticipated risks," Haverland says. "Unexpected events can happen and such developments typically affect some assets more than others."

During periods of calmer markets, a diversified portfolio may not get returns quite as high as the overall market. But over long periods of time that include both bull and bear markets, we believe diversified portfolios can help investors achieve their financial goals, Haverland says.

A Changing Leaderboard. Why are diversification and asset allocation such important investing strategies? Asset performance can vary greatly from year to year, and diversification — holding a variety of assets that have behaved differently during changing economic or market conditions — may help you during bouts of volatility. Six cars — representing commodities, hedge funds, high yield fixed income, investment grade fixed income, emerging market equity, and U.S. large cap equity — are shown over a six-year period from 2012 to 2017, with their positions moving depending on the year and their rate of return for that year.

Know your diversification options

Any investor can construct a diversified portfolio, even if it's made up of only publicly traded stocks and bonds. But high-net-worth investors may have additional choices, Haverland notes.

"These investors may have less need for liquidity or may meet certain thresholds for alternative products, allowing for a wider array of strategies to choose among," he says.

For example, many alternative investments can't be liquidated as quickly as securities traded on public exchanges. That means an investor's money is invested for longer periods. But for high-net-worth individuals who can safely go without access to their funds for several years, an investment professional may recommend some of alternative products to further diversify an overall portfolio.

Regardless of particular investment choices, though, we believe diversification is a key strategy.

"We believe employing a diversified strategic asset allocation based on investor goals and risk tolerance, along with regular rebalancing, offers the optimal approach for investors over the long term," Haverland says.

Mark Tosczak has spent 25 years wrangling words for newspapers, magazines, businesses, nonprofits, and other organizations. He focuses on health care, science, and business.

Image by iStock

What can Wells Fargo do for you?

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Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A.

Diversification is an investment method used to help manage risk. It does not ensure a profit or protect against a loss including in a declining market. All investing involves risk including the possible loss of principal.

Both stocks and bonds involve risk and their returns and risk levels can vary depending on prevailing market and economic conditions.  Bond prices fluctuate inversely to changes in interest rates. Alternative investments trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions.  Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the investor.

Asset Allocation Chart – Index Definitions

Commodities: The Bloomberg Commodity Index is calculated on an excess return basis and reflects commodity futures price movements.

Hedge Funds: The HFRI Fund Weighted Composite Index is a fund-weighted (equal-weighted) index designed to measure the total returns (net of fees) of the approximately 2,000 hedge funds that comprise the Index.

High Yield Fixed Income: The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market.

Investment Grade Fixed Income: The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.

Emerging Market Equity: The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure emerging markets equity performance.

U.S. Large Cap Equity: The S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. Returns assume reinvestment of dividends and capital gain distributions.

Asset Class Risks
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stocks may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Bonds are subject to interest rate, credit/default, call, liquidity, inflation and other risks. Bond prices rise as interest rates fall. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Hedge funds trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the investor.

This information is provided for educational and illustrative purposes only.

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