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Simply put, diversification means spreading your savings among multiple investment options. It's the financial version of the old adage "Don't put all your eggs in one basket." If your eggs are in one basket and that basket falls to the ground, you're left with nothing but broken eggs.
Diversification, on the other hand, is a little like insurance against a falling basket. By investing in multiple asset categories—stocks, bonds, cash and real estate, to name a few—you can reduce the overall impact if performance from any one category is poor.
The benefits of diversification
Look no further than stock market returns over the last 25 years to see the benefits of diversification. If you bought just one stock in 1982, say it was IBM, you'd have had negative returns in 8 of those years.
By contrast, if you'd invested in large-company stocks, as represented by the Standard & Poor's 500 Index, you'd have experienced negative returns in only 4 years. While IBM is part of the S&P 500 Index, some of the index's 499 other stocks were in positive territory while IBM was down.
Build your own diversification chart. In the following chart, the blue line represents IBM, a single stock. Click the S&P 500 stocks button to see the difference in volatility and return between this one stock and many stocks.
Add additional diversification by clicking the 60% stocks and 40% bonds button. The 25-year average annual returns record may surprise you.
Click yellow buttons above to see volatility.
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Source: S&P Micropal, 12/31/06. Volatility chart traces annual returns for each of the following: one stock (IBM), 100% stocks (S&P 500 Index) and a combination of 60% stocks/40% bonds (S&P 500 Index and Lehman Brothers Aggregate Bond Index). Indexes are unmanaged and unavailable for direct investment. This chart illustrates past results only and does not represent or predict the performance of any Franklin Templeton fund.
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Different ways to diversify
You can diversify within an asset category, across asset categories and even outside the U.S.
Diversifying within an asset category. By diversifying, you can help reduce the impact of a specific underperforming security. You could do this by purchasing many bonds, for example, instead of one or two.
You're not really diversified, however, if all those bonds are municipal bonds from the state you live in. Diversification means owning different types of bonds—long term, short term, government, corporate and possibly high yield.
Diversifying among asset categories. Diversifying can also help reduce the risk that an entire asset category, such as stocks, will do poorly for an extended period of time. You can select investments from several asset categories—stocks, bonds, cash and real estate, for example.
Diversifying outside the U.S. Diversification can also help reduce the impact if U.S. financial markets were to suffer an extended bear market. While global investing includes additional risks, such as currency fluctuations and political uncertainty, diversifying outside the U.S. can help offset overall portfolio volatility.
Mutual funds—the easiest way to diversify
Many people simply don't have enough money to invest in a broad array of individual stocks, bonds and other assets, much less the time and energy to research and monitor them. For those investors, mutual funds may represent the most sensible option.
Mutual funds are diversified by definition. A single fund can hold securities from hundreds of issuers. Mutual funds provide an easy and cost-effective way to diversify within asset categories, across asset categories and outside the U.S.
Front-end, and in some cases back-end sales loads, management fees, Rule 12b-1 fees and other expenses are associated with Franklin Templeton mutual fund investments. Investment returns for a fund are reduced by these fees and expenses.
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