The guide to diversification

Build a long-term investment strategy to help realize your goals.

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Key takeaways

  • Diversification can help manage risk.
  • You may avoid costly mistakes by adopting a risk level you can live with.
  • Rebalancing is a key to maintaining risk levels over time.

It's easy to find people with investing ideas—talking heads on TV, your neighbor, or an "inside tip" from a broker. But these kinds of opportunistic ideas aren't a replacement for a real investment strategy.

We believe that setting and maintaining your strategic asset allocation are among the most important ingredients in your long-term investment success. No matter what your situation, this means creating an investment mix based on your goals, risk tolerance, financial situation, and timeline; and being diversified both among and within different types of stocks, bonds, and other investments.

Then give your portfolio a regular checkup. At the very least, you should check your asset allocation once a year or any time your financial circumstances change significantly—for instance, if you lose your job or get a big bonus. Your checkup is a good time to determine if you need to rebalance your asset mix or reconsider some of your specific investments.

Why diversify?

The goal of diversification is not necessarily to boost performance—it won't ensure gains or guarantee against losses. But once you choose to target a level of risk based on your goals, time horizon, and tolerance for volatility, diversification may provide the potential to improve returns for that level of risk.

To build a diversified portfolio, you should look for assets—stocks, bonds, cash, or others—whose returns haven't historically moved in the same direction and to the same degree; and, ideally, assets whose returns typically move in opposite directions. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much. Thus, you can potentially offset some of the impact that a poorly performing asset class can have on an overall portfolio.

Another important aspect of building a well-diversified portfolio is trying to stay diversified within each type of investment.

Within your individual stock holdings, beware of overconcentration in a single stock. For example, you may not want one stock to make up more than 5% of your stock portfolio. Fidelity also believes it’s smart to diversify across stocks by market capitalization (small, mid, and large caps), sectors, and geography. Again, not all caps, sectors, and regions have prospered at the same time, or to the same degree, so you may be able to reduce portfolio risk by spreading your assets across different parts of the stock market. You may want to consider a mix of styles too, such as growth and value.

Similarly, when it comes to your bond investments, consider varying maturities, credit qualities, and durations, which measure sensitivity to interest-rate changes.

Diversification has proven its long-term value

During the 2008–2009 bear market, many different types of investments lost value to some degree at the same time, but diversification still helped contain overall portfolio losses.

Consider the performance of 3 hypothetical portfolios: a diversified portfolio of 70% stocks, 25% bonds, and 5% short-term investments; an all-stock portfolio; and an all-cash portfolio. As you can see in the table below, a diversified portfolio lost less than an all-stock portfolio in the downturn, and while it trailed in the subsequent recovery, it easily outpaced cash and captured much of the market's gains. A diversified approach helped to manage risk, while maintaining exposure to market growth.

The high price of bad timing

Why is it so important to have a risk level you can live with? As the example above illustrates, the value of a diversified portfolio usually manifests itself over time. Unfortunately, many investors struggle to fully realize the benefits of their investment strategy because in buoyant markets, people tend to chase performance and purchase higher-risk investments; and in a market downturn, they tend to flock to lower-risk investment options; behaviors which can lead to missed opportunities. The degree of underperformance by individual investors has often been the worst during bear markets. Studies have consistently shown that the returns achieved by the average stock or bond fund investor have lagged the reported returns of the average stock or bond index, often by a large margin.

The data from DALBAR shows that the average fund investor trailed benchmark indexes significantly. (See chart.) This means the decisions investors make about how to diversify, the time the choose to get into or out of the market, as well as fees they pay or underperforming funds they choose, cause them to generate returns far lower than the overall market.

"Being disciplined as an investor isn't always easy, but over time it has demonstrated the ability to generate wealth, while market timing has proven to be a costly exercise for many investors," observes Ann Dowd, vice president at Fidelity Investments. "Having a plan that includes appropriate asset allocation and regular rebalancing can help investors overcome this challenge."

Building a diversified portfolio

To start, you need to make sure your asset mix (e.g., stocks, bonds, and short-term investments) is aligned to your investment time frame, financial needs, and comfort with volatility. The sample asset mixes below combine various amounts of stock, bond, and short-term investments to illustrate different levels of risk and return potential.

Diversification is not a one-time task

Once you have a target mix, you need to keep it on track with periodic checkups and rebalancing. If you don't rebalance, a good run in stocks could leave your portfolio with a risk level that is inconsistent with your goal and strategy.

What if you don't rebalance? The hypothetical portfolio shows what would have happened if you didn’t rebalance a portfolio from 2009–2016: The stock allocation would have grown dramatically. (See chart.)

The resulting increased weight in stocks meant the portfolio had more potential risk at the end of 2016. Why? Because while past performance does not guarantee future results, stocks have historically had larger price swings than bonds or cash. This means that when a portfolio skews toward stocks, it has the potential for bigger ups and downs.2

Rebalancing is not just a risk-reducing exercise. The goal is to reset your asset mix to bring it back to an appropriate risk level for you. Sometimes that means reducing risk by increasing the portion of a portfolio in more conservative options, but other times it means adding more risk to get back to your target mix.

A 3-step approach

Investing is an ongoing process that requires regular attention and adjustment. Here are 3 steps you can take to keep your investments working for you:

1. Create a tailored investment plan

If you haven't already done so, define your goals and time frame, and take stock of your capacity and tolerance for risk.

2. Invest at an appropriate level of risk

Choose a mix of stocks, bonds, and short-term investments that you consider appropriate for your investing goals.

Stocks have historically had higher potential for growth, and holding them for longer time periods can help to smooth out volatility.

On the other hand, if you'll need the money in just a few years—or if the prospect of losing money makes you too nervous—consider a higher allocation to generally less volatile investments such as bonds and short-term investments. By doing this, of course, you'd be trading the potential of higher returns for the potential of lower volatility.

Once you have chosen an asset mix, research and select appropriate investments.

3. Manage your plan

We suggest you—on your own or in partnership with an investment professional—do regular maintenance for your portfolio. That means:

  • Monitor – Evaluate your investments periodically for changes in strategy, relative performance, and risk.
  • Rebalance – Revisit your investment mix to maintain the risk level you are comfortable with and correct drift that may happen as a result of market performance. As a general guideline, you may want to consider rebalancing if any part of your asset mix moves away from your target by more than 10 percentage points.
  • Manage taxes – Decide how to implement tax-loss harvesting, tax-savvy withdrawal, and asset location strategies to manage taxes.
  • Refresh – At least once a year, or whenever your financial circumstances or goals change, revisit your plan to make sure it still makes sense.

The bottom line

Achieving your long-term goals requires balancing risk and reward. Choosing the right mix of investments and then periodically rebalancing and monitoring your choices can make a big difference in your outcome.

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Before investing, consider the investment objectives, risks, charges and expenses of the fund or annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a free prospectus and, if available, summary prospectus containing this information. Read it carefully.
This information is intended to be educational and is not tailored to the investment needs of any specific investor.

Past performance is no guarantee of future results.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Investing in a variable annuity involves risk of loss—investment returns and contract value are not guaranteed and will fluctuate.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.

Indexes are unmanaged and you cannot invest directly in an index.
The S&P 500 Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Wilshire 5000 is a market capitalization–weighted index of approximately 7,000 stocks.
The Barclays Global Aggregate Bond Index is an unmanaged market value–weighted index representing securities that are SEC registered, taxable, and dollar denominated.
The Barclays U.S. Aggregate Bond Index is a market value–weighted index of investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more.
The MSCI® EAFE® (Europe, Australasia, Far East) Index is a market capitalization–weighted index that is designed to measure the investable equity market performance for global investors in developed markets, excluding the U.S. and Canada.
The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index that is designed to measure equity market performance in the emerging-market countries.
The FTSE NAREIT Equity-Only Index is an unmanaged, market value–weighted index based on the last closing price of the month for tax-qualified REITs listed on the NYSE.
The Dow Jones AIG Commodity Index is a rolling commodities index composed of futures contracts on 19 physical commodities traded on U.S. exchanges. The index serves as a liquid and diversified benchmark for the commodities asset class.
The Ibbotson U.S. Intermediate-Term Government Bond Index is a custom index designed to measure the performance of intermediate-term U.S. government bonds.
The Barclays U.S. Intermediate Government Bond Index is a market value–weighted index of U.S. government fixed-rate debt issues with maturities between one and 10 years.
The Ibbotson Associates SBBI 30 Day T-Bill Total Return Index is an index that reflects U.S. Treasury bill returns. Data from the Wall Street Journal are used for 1977–present; the CRSP U.S. Government Bond File is the source from 1926 to 1976. Each month a one-bill portfolio containing the shortest-term bill having not less than one month to maturity is constructed.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
1. Source: Strategic Advisers. Portfolio risk is measured using standard deviation, which is a statistical measure of how much a return varies over an extended period of time. The more variable the returns, the larger the standard deviation. Investors may examine historical standard deviation in conjunction with historical returns to decide whether an investment’s volatility would have been acceptable given the returns it would have produced. A higher standard deviation indicates a wider dispersion of past returns and thus greater historical volatility. Standard deviation does not indicate how an investment actually performed, but it does indicate the volatility of its returns over time. Standard deviation is annualized. The returns used for this calculation are not load adjusted.
2. Historical returns for the various asset classes are based on performance numbers provided by Ibbotson Associates in the Stocks, Bonds, and Inflation (SBBI) 2001 Yearbook (annual update work by Roger G. Ibbotson and Rex A. Sinquefield). Domestic stocks are represented by the S&P 500® Index, bonds are represented by U.S. intermediate-term government bonds, and short-term assets are based on the 30-day U.S. Treasury bill. Foreign equities are represented by the Morgan Stanley Capital International Europe, Australasia, Far East Index for the period from 1970 to the last calendar year. Foreign equities prior to 1970 are represented by the S&P 500® Index.
DALBAR study: DALBAR is an independent, Boston-based financial research firm. Using monthly fund data supplied by the Investment Company Institute, QAIB calculates investor returns as the change in assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions, and exchanges for the period.
Equity performance is represented by the Standard & Poor's 500 Composite Index, an unmanaged index of 500 common stocks generally representative of the U.S. stock market. S&P 500® and S&P are registered service marks of The McGraw-Hill Companies, Inc., and are licensed for use by Fidelity Distributors Corporation and its affiliates. Fixed income performance is represented by the Barclays Capital Aggregate Index. The Barclays Capital Aggregate Index is an unmanaged market value–weighted index representing securities that are SEC registered, taxable, and dollar denominated. This index covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. Past performance is no guarantee of future results. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index.
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