How Diversification Protects Your Portfolio When Markets Swing
Why Diversification Matters
Diversification is one of the most powerful tools for building long-term financial success.
Instead of betting on a single stock or sector, you spread your money across different types of investments. The goal is simple: similar long-term returns with a smoother, less stressful ride.
To understand why it works, we need to look at some basic math.
Understanding Returns (the Simple Part)
Imagine a series of yearly returns like this:
- +4%
- –5%
- +9%
- –1%
If we add them together, we get a total return of +7%. That’s a straightforward, linear calculation.
Returns work in a relatively simple way: we can add and average them to see how much we earned over time.
Measuring the “Bumpiness” (the Less Simple Part)
But returns don’t tell us how it felt to be invested during those years.
Some years are up, some are down. The amount they move around is called volatility - or, in math terms, standard deviation.
To measure that volatility, we:
- Calculate the average return.
- Look at how far each year’s return is from that average.
The bigger those differences, the “bumpier” the ride.
The Magic of Combining Investments
Here’s where diversification gets powerful.
When we combine two different investments - say, U.S. stocks and international stocks, or stocks and bonds - something interesting happens:
The combined portfolio often has less volatility than simply adding up the risk of each investment on its own.
In other words, the standard deviation of the portfolio is usually less than the sum of the standard deviations of the individual pieces.
This happens because different investments don’t always move in the same direction at the same time. When one is down, another may be flat or up. The ups and downs partially offset each other.
Why Diversification Works for You
Here’s the core idea:
We can aim for similar long-term returns while taking on less risk by combining different types of investments.
Returns add up in a straightforward way over time. Variability does not.
By owning a mix of investments - different asset classes, regions, and types of companies - you can:
- Reduce how much your portfolio swings day to day.
- Stay invested through rough markets.
- Increase your chances of reaching your long-term goals.
For a high-earning tech professional with RSUs, a 401k, and a taxable account, this might mean:
- A blend of U.S. and international stocks.
- Large and small companies.
- Some bonds for stability.
- Regular rebalancing to keep everything in line.
This is why diversification works: you can pursue the returns you need with less risk.
Building Your Diversified Portfolio
This “mathematical magic” is at the heart of a strong investment plan. A well-designed financial plan deserves a well-diversified investment strategy supporting it.
Your Investment Plan
Ask yourself:
- Is your investment plan set up to take full advantage of this diversification “magic”?
- Does it include diversification within asset classes (for example, across many different stocks) and between asset classes (stocks, bonds, and other investments)?
- Is your portfolio rebalanced regularly so you maintain your strategy, even when markets move?
If you’re not sure, that’s exactly what we help clients figure out.