The Power of Portfolio Diversification

You. So, today, we’re going to talk through a quick example to show the importance of diversification in your portfolio. So, what we have here on the screen is real data from the S and P 500 from 2009 to 2020. So, looking at a sample period of returns, and it’s assuming that somebody invested $$100,000 on October 9, 2007. So, after that time, the market went down, as you can see, 54.9%. So your 100,000 would have turned to 45. And then there’s a big rebound from 45 up to 280. Big return of 528, another downturn of 33%, and then back up. So it was a rocky ride, but over those years, your 100,000 would have turned to 319. So not bad. However, our example on the right shows what happens if we take roughly half of the down and half of the up.

So, minimizing both the downside and the upside, which, in essence, is exactly what diversification in your portfolio does. In theory, it caps the downside and the upside of your return. So let’s go through the same example. So, 100,000 invested. Now, instead of going down 55%, we go down 34. So 100 turns to 66. And then now, instead of going up 528%, up 327. So, 65 goes to 282. And then instead of dropping 33%, drop 21%. And then, at the end of the day, your 100,000 turned to 320. So, despite winning less here, instead of 528 only getting 327, instead of getting the 70% return, we’re getting 43. So, although we’re capping the upside, we’re also capping the downside. And the end result is within $1,000 of each other.

So this is important because while it sounds good in theory to just ride out downturns, if we go down too far, it really puts a lot of pressure on future returns, which is what this graph is showing here. So, this is showing if we go down 5%, we need a 5.3% return. If we go down 20%, we need a 25% return. And then if we go down 50%, we need 100% rate of return to get back to where we started. So if we focus on this example, if we think if we start with 100,000 and go down 50% and back up 50%, most times whenever we ask somebody that question, like, where are we at the end, they’re going to say 100,000, because we started with 100, went down 50 and up 50, we’re back at 100.

But in that example, if we go down 50%, our future return is now working off of a lower number, so now we need that much more to get back to. Even so, while we’re very focused on making sure that we achieve good high returns over the long term, we also need to be cognizant of minimizing those downswings as well. We don’t want to put ourselves in a position where the loss is too big of a loss to recover from. Given, depending on where you’re at in your financial plan, this becomes more and more important. For example, if you’re retired, may not have a lot of time to recoup those losses. So really important that if we’re investing, that we’re doing so in a diversified manner and not putting too many eggs in one basket here.

So hope these examples were helpful and let us know if you have any questions.

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