Portfolio diversification is a key to financial management


Chris Walden

Stock markets in the United States and around the world have been down 20% to 30% or more so far this year. The Federal Reserve has aggressively raised interest rates and tightened monetary policy, inflation is at a 40-year high and geopolitical risks are heightened.

Most bond asset classes have continued to perform negatively this year as interest rates have pushed the value of existing bonds down. The good news is that interest rates paid on cash and short-term bonds have risen to levels not seen in more than a decade.

How do investors deal with declining balances in their retirement plans and other investments?

First, it’s important to be patient and try to take the emotion out of investing. Diversifying your portfolio and rebalancing during times of high market volatility can also help investors weather the storm.

Being patient doesn’t mean ignoring your investment portfolio. I believe you should always know where your money is and how it is performing. But you shouldn’t always react, especially by selling, when you see your portfolio falling in value.

Over the past 15 years, the S&P 500 Index, a common benchmark for the United States stock market, has produced an average annual return of over 10%. Annual performance was negative for three years.

The lowest return over this period was -37% in 2008 and the highest return was 32.4% in 2013. If an investor were to panic and sell after 2008, it would have resulted in a huge loss. Patience would have allowed the investor to benefit from higher returns in the years following the big loss.

Investing your entire portfolio in the S&P 500 Index or an individual index may not be the best strategy. This is where diversifying and rebalancing your portfolio helps.

With diversification, your investment funds are spread across several asset classes. Rather than investing solely in US stocks, a diversified investment portfolio can include cash, bonds (both US and foreign), international stocks, real estate, commodities, and other asset classes.

Investing in bonds has historically added safety to portfolios, although as mentioned, 2022 was a challenging year. Bonds pay interest, so a positive return flows back into the portfolio. Bonds also mature at par, so the issuer guarantees that the bondholder will get back their original investment. These factors contribute to the relative safety of bonds, making them a desirable complement to stocks in a portfolio.

Rebalancing your portfolio after significant market volatility returns the portfolio to its intended allocation. Typically, this involves buying asset classes that have performed negatively and selling some asset classes that have performed well. This is often referred to as “buy low and sell high”.

Portfolio rebalancing should be done taking into account current market and economic conditions. The right mix of asset classes, when actively managed and rebalanced, can increase returns and reduce risk in an investment portfolio.

While periods of market volatility can be stressful, patience, diversification, and rebalancing can be good tactics for the long-term investor.

Chris Walden is a certified financial planner and an active member of the Financial Planning Association of Greater Kansas City. He serves as an investment advisor to Heartland Capital Advisors, LC, a registered investment advisor in Independence.

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