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Using diversification to help manage risk and return

Wells Fargo Investment Institute

Sunrise over a city

Despite the uncertainty of 2020, all major asset classes posted positive returns. U.S. small-cap equity was the best-performing asset class, followed closely by emerging market equity and U.S. large-cap stocks.

Because forecasting market performance is challenging, we believe it’s important to hold a diversified portfolio, even though it has historically produced lower returns than if you were able to pick the best performer in any given year. Among its potential benefits, we believe diversification is likely to generate more consistent returns. As a result, over the long term, a diversified portfolio may increase more in value than one that produces more volatile returns. Of course, diversification does not guarantee investment returns or eliminate the risk of loss.

Many investors “watch the markets” by following the widely reported Dow Jones Industrial Average or S&P 500 Index. If these market indicators are the only ones an investor considers, they can often miss what’s happening in other markets, including overseas. That’s because the world of investments is significantly more diverse than these two domestic large-cap equity indexes.

During some periods, certain asset classes will underperform these indexes, while in other periods the opposite holds true. This disparity in returns from one time period to the next often affects how a well-diversified portfolio performs when compared with a single-market index.

A diversified portfolio’s most important benefit may be that it can help mitigate the effects of unanticipated risks. Unexpected events can happen at any time, and such developments typically affect some assets more than others. We believe the best approach for investors to deal with uncertainty is to hold a diversified portfolio that includes some asset classes that tend to be less impacted by market surprises.

Of course, the notion of hedging against uncertainty comes with a trade-off. Adding assets to a portfolio can increase the likelihood that some will not perform as well as others. And this could potentially dampen portfolio returns at times, particularly when markets are calm.

Once your asset allocation is set, we believe it’s important to rebalance your portfolio, at least annually, back to your intended allocation if the markets have moved significantly or you’ve experienced a noteworthy life event (a birth, death, divorce, etc.). It’s likely you’ll be better off ignoring day-to-day fluctuations in the markets and focusing instead on your long-term plan.

So it all boils down to this: Diversification has helped investors manage risk and return, but it did so at a potential cost. One way to calculate that cost is to look at the difference in any given year between a diversified portfolio’s return and that of the year’s best-performing asset. Rather than diversifying, an investor could potentially get better returns if he or she were able to pick the best-performing asset at the beginning of each year. But there’s the rub. Even seasoned investors find it difficult, if not impossible, to pick the best performer on a consistent basis. That’s a primary reason why we recommend investors diversify.

Read the full report (PDF)