INVESTING 101

A MASTERCLASS IN DIVERSIFICATION: THE BENEFITS IN PORTFOLIOS

Daniel Prince, CFA Nov 01, 2023 CORE

THREE TAKEAWAYS

  1. Recent stock market volatility has proven why diversification is important and can help reduce risk in portfolios.
  2. Index funds can help all investors diversify at the single-stock and portfolio levels, including asset allocation ETFs.
  3. Investors can consider using iShares Core ETFs to build a low cost, diversified portfolio as they pursue their long-term investing goals.
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Historians, economists, and social scientists will long study the last decade for lessons on human behavior. For the average investor, though, a key lesson already stands out: There’s wisdom in diversification.

Diversification is the practice of not holding all your eggs in one basket, thereby owning a mix of stocks with different business activities, as well as other investments like bonds. This cornerstone investment principle was born in the 1950s, helped spur the advent of index mutual funds in the 1970s, then drove the rise of index-tracking exchange traded funds (ETFs) starting in the 1990s.1

Index funds give all investors simple and low-cost access to diversified investment strategies and, in recent decades, helped individuals move from owning individual stocks, which bring with them unique and concentrated risks, to increasingly global strategies spanning stocks, bonds and more. Take iShares Core ETFs as an example, which allow investors to build a low cost, diversified portfolio with as little as one fund.

So, what has diversification and index funds done for investors recently?

SPREADING THE RISK AROUND THROUGH DIVERSIFICATION

Over the last few years investors have been whipsawed by unprecedented market events. Steep declines tied to COVID-19 were followed by a sharp rebound in U.S. stocks, only to give way to losses driven by inflation and slowing growth.

Despite this wild ride, over the last five years, patient investors have been rewarded as U.S. stock indexes have risen almost 100%.2 But, while the market has gone up, not all stocks have been a good investment. 39% of U.S. stocks declined during that same period, meaning investors picking stocks from the broad market had a greater than one out of three chance of selecting a loser. And many of the stocks that fell, fell hard. Among the U.S. stocks that declined over the last five years, the average drop was 52%.2 In other words, almost a third of stocks lost half their value. If buying single stocks, it could have been easy to be a loser in a winning market.

Don’t be a loser in a winning market

5-year returns as of 10/31/2024

Doughnut chart showing the percentage of U.S. stocks that have gone up vs. down in value over the last five years.

Source: Morningstar (covering period Nov. 1, 2019 to Oct. 31, 2024). U.S. stock market as measured by the S&P Total Market Index, using cumulative total return which assumes the reinvestment of dividends. Past performance is not indicative of future results. Indexes are unmanaged and one cannot invest directly in an index.

Chart description: Doughnut chart showing the percentage of U.S. stocks that have gone up vs. down in value over the last five years (through 10/31/2024).

WINNERS AND LOSERS

Over the last few years, the pendulum has swung dramatically between market leaders and market laggards. The COVID-19 sell off disproportionately impacted airlines and hotels as stay at home darlings like Zoom Video Communications and Peloton reigned supreme.3 When doors began to reopen and inflation rose at levels unseen in decades, the tech darlings sold off in dramatic fashion while unloved sectors from years past, like energy, were resurrected. In fact, energy was the worst performing sector in 2019 and 2020 but the following 2 years it was the best performing sector. In 2023, tech benefitted from the boom in AI companies while energy reversed in performance given weaker global growth.4
Bar charts showing the YTD and calendar year returns of U.S. technology stocks and U.S. energy stocks relative to the U.S. stock market.

Source: Morningstar as of 10/31/2024. U.S. stock market represented by the S&P 1500 index, Technology represented by the S&P 1500 Information Technology index and Energy represented by the S&P 1500 Energy index. Using total return which assumes the reinvestment of dividends. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Chart description: Bar charts showing the YTD (through 10/31/2024) and calendar year returns of U.S. technology stocks and U.S. energy stocks relative to the U.S. stock market. Positive numbers indicate outperformance while negative numbers indicate underperformance.

KEEPING AN EYE ON THE LONG-TERM

The point is that successfully timing the market with individual securities or even whole sectors — buying and selling at just the right times — is difficult even for the most experienced investor. In fact, chasing the latest high-flying investment can cause harm to a portfolio’s long-term returns. Some index ETFs can hold the whole market, a strategy which can help investors avoid sharp declines of a few stocks or sectors.

SUMMING IT UP

Diversification helps investors to navigate fast-changing markets and stay the course to pursue their financial goals. The past few years have offered a masterclass in how diversification through index-based ETFs could have helped the average investor avoid losing in a winning, albeit volatile, market.
Photo: Daniel Prince, CFA

Daniel Prince, CFA

U.S. Head of iShares Product

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Brad Zucker, CFA

Product Consultant

Contributor

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