Diversification can help you tackle uncertainty
Stock market volatility is likely to continue in 2023 — and that’s where diversification may be able to help.
Diversification, or investing in a wide array of assets, can help manage risk. We’ll look at why that matters in 2023 and share some data to help you decide whether diversifying your investments may be a good fit.
Why diversification is important
The stock market, in the long run, trends toward growth. But as seen in the graph below, decades of growth are still peppered with periods of decline. And even when you’re committed to investing over a long stretch, market volatility can feel unsettling.
The volatility effect
During bull markets, diversification isn’t always a priority, but in volatile markets it can help smooth returns.Footnote 1
Animated line chart begins with expanding x and y-axes with the x-axis representing Year from 1975 to 2022 in intervals of eight and the y-axis representing the S&P 500 Index from 0 to 5,000 in intervals of 500.
The line begins at about 50 in 1975, staying relatively flat but rising slowly to 500 in 1993. From there, the line rises at a faster pace to 1,500 in 2001 before falling back to 1,000 by 2003. There is another rise back up to 1,500 in 2008 before taking a sharp decline to 1,000 in 2009. From there, the line rises, first gradually and then at a more rapid pace, climbing to 3,000 in 2018 and then to 5,000 in 2020.
An expanding highlighted area zooms in on the data between 2020 and 2022, showing the sharpest downward trend on the chart from 5,000 in 2020 to just below 4,000 in 2022.
Investing in assets that aren't correlated to the stock market — meaning they don't follow the same performance pattern — can potentially help offset how market volatility impacts your portfolio. And while you might choose bonds, stocks and bonds are somewhat correlated. To truly diversify, you may need to think beyond bonds.
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Investing basics: Why diversification is important
The diversification benefit
By potentially helping offset volatility, diversification may help smooth returns over the long run. The chart below shows how a portfolio made up of stocks and bonds performed compared to a portfolio of different asset groups, including various categories of stocks and bonds, real estate, and commodities.
The hedging effect
While a more diverse portfolio underperformed from 2012-2021...Footnote 2
Animated line chart begins with a coordinate plane that slides up from the bottom of the frame with the y-axis defined as 3 year rolling returns with a scale of 4.5% from 18% in intervals of 4.5% and the x-axis defined as year from 2012 to 2022 in intervals of one.
Two categories appear in the key at the top of the chart with silver defined as 60% stocks / 40% bonds and gold defined as Diversified across 10 asset groups. We see the silver line advance across frame, beginning at just below 13.5% in 2012, rising and falling between 9% and 15% from 2012 to 2014, before decreasing to 7% in 2017. From there, the line rises and falls between 7% and 12% between 2017 and 2021 before spiking to about 17% and then falling back to just below 9% in 2022.
The line for Diversified across 10 asset groups begins at the same point as the silver line for 60% stocks / 40% bonds at about 13.5% in 2012, remaining about 4 percentage points below the silver line but rising and falling at the same rate from 2012 to mid-2018 where the two lines meet at about 8%. From there, the gold line is slightly below but close to the silver line, rising and falling between 5% and 9% from mid-2018 to mid-2020. There is a sharp decline to about 3% in 2020, before spiking to about 13.5% and then falling back to about 8% in 2022.
It performed better in 2022.Footnote 2
Animated vertical bar chart begins with defined negative values on the y-axis from 0% at the top to -15% at the bottom in intervals of -5%. Silver and gold bars drop down from the top, with the silver bar dropping to -15.5% and the gold bar dropping to -11.2%. Then we see the labels for each bar come into view with silver representing 60% stocks / 40% bonds and gold representing Diversified across 10 asset groups.
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Why asset allocation matters in uncertain times
Diversification in today’s markets
If you’ve been investing primarily in the last 15 years and have been keen to maximize potential returns, you might not have seen a reason to prioritize diversification. But for many, the current economic and market uncertainty casts diversification in a different light. For instance, investments reacted to the COVID-19 pandemic in vastly different ways.
A closer look at correlation
Diversification works best when investments react differently to stimuli, like the 2020 lockdowns or 2021 recovery.Footnote 3
Animated horizontal bar chart with x and y-axes gradually expanding into view.
The x-axis has a scale of -0.5% to 30% in intervals of 5%. The y-axis has four defined categories: 1) US Large Cap Equity: S&P 500 Index, 2) Global Hedge Funds: HFRI Fund Weighted Composite Index, 3) Commodities Bloomberg Commodity Index, and 4) Emerging Market Equity: MSCI Emerging Markets Index.
From there, a key appears at the top with silver representing 2020 Returns and gold representing 2021 Returns. Horizontal bars begin to slide across the frame, showing first the 2020 and then the 2021 Returns for each of the four categories on the y-axis.
Approximate data points are as follows: US Large Cap Equity, 20% for 2020 and 30% for 2021. Global Hedge Funds, 13% for 2020 and 11% for 2021. Commodities, -0.4% for 2020 and 28% for 2021. Emerging Market Equity, 20% for 2020 and -0.3% for 2021.
If you’re looking for investments that are not correlated to the stock market, investment products such as:
- mutual funds
- exchange-traded funds (ETFs)
- real estate investment trusts (REITs)
offer exposure to diverse asset classes, including real estate, commodities, derivatives, and private equity. Which of these you decide to include in your portfolio will likely depend on your personal goals, circumstances, and risk tolerance.
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Regaining altitude with alternatives
The bottom line on diversification
Diversification is an important component of long-term investing. The current uncertainty may be a perfect opportunity to set yourself up for financial success by diversifying in whatever way makes sense for you.
Your team of dedicated Wells Fargo specialists is here to help you with a goals-based approach and personalized support.
- Your Wells Fargo Advisors financial advisor assists you in creating a customized investment plan to help you achieve your goals
- Your Wells Fargo Bank premier banker is your primary point of contact for banking resources and can refer you to a Wells Fargo Advisors financial advisor for your investing needs