By Daniel Prince, CFA
Historians, economists, and social scientists will long study the last decade for lessons on human behavior. For the average investor, though, a key lesson already stands out: There's wisdom in diversification.
Diversification is the practice of not holding all your eggs in one basket, thereby owning a mix of stocks with different business activities, as well as other investments like bonds. This cornerstone investment principle was born in the 1950s, helped spur the advent of index mutual funds in the 1970s, then drove the rise of index-tracking exchange-traded funds (ETFs) starting in the 1990s.1
Index funds give all investors simple and low-cost access to diversified investment strategies and, in recent decades, helped individuals move from owning individual stocks, which bring with them unique and concentrated risks, to increasingly global strategies spanning stocks, bonds and more. Take iShares Core ETFs as an example, which allows investors to build a low cost, diversified portfolio with as little as one fund.
So, what has diversification and index funds done for investors recently?
Over the last few years, investors have been whipsawed by unprecedented market events. Steep declines tied to COVID-19 were followed by a sharp rebound in U.S. stocks, only to give way to losses driven by inflation and slowing growth. In fact, the first four months of 2022 marked the 3rd worst start to a year for U.S. stocks since 1926.2
Despite this wild ride, over the last five years, patient investors have been rewarded as U.S. stock indexes have risen over 80%.3 But, while the market has gone up, not all stocks have been a good investment. 36% of U.S. stocks declined during that same period, meaning investors picking stocks from the broad market had a greater than one out of three chances of selecting a loser. And many of the stocks that fell, fell hard. Among the U.S. stocks that declined over the last five years, the average drop was 52%.3 In other words, one in three stocks lost half their value. If buying single stocks, it could have been easy to be a loser in a winning market.
Don't be a loser in a winning market
Over the last few years, the pendulum has swung dramatically between market leaders and market laggards. The COVID-19 sell off disproportionately impacted airlines and hotels as stay-at-home darlings like Zoom Video Communications and Peloton reigned supreme.4 When doors began to reopen and inflation rose at levels unseen in decades, the tech darlings sold off in dramatic fashion while unloved sectors from years past, like energy, were resurrected. In fact, energy was the worst-performing sector in four of the last five years but is outperforming the market by a whopping 70.8% in 2022 through the end of May.5
The point is that successfully timing the market with individual securities or even whole sectors - buying and selling at just the right times - is difficult even for the most experienced investor. In fact, chasing the latest high-flying investment can cause harm to a portfolio's long-term returns. Some index ETFs can hold the whole market, a strategy which can help investors avoid sharp declines of a few stocks or sectors.
Diversification helps investors to navigate fast-changing markets and stay the course to pursue their financial goals. The past few years have offered a masterclass in how diversification through index-based ETFs could have helped the average investor avoid losing in a winning, albeit volatile, market.
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1 See Harry Markowitz's 1952 thesis, Portfolio Selection, available at www.jstor.org/stable/2975974.
2 Measured by U.S. stock market returns from Jan 1 to April 30 of each calendar year. U.S. stocks represented by the S&P 500 index from 3/4/57 to 4/30/22 and the IASBBI U.S. Lrg Stock TR USD Index from 7/1/26 to 3/4/57. Past performance is not indicative of future results. Indexes are unmanaged and one cannot invest directly in an index.
3 U.S. stock market as measured by the S&P Total Market Index. Morningstar (covering period May 31, 2017, to May 31, 2022).
4 As of 5/31/2022, weights for these companies in the highlighted iShares funds are as follows: Zoom Video Communications: ITOT: 0.06%, AOK, AOM, AOR and AOA: 0.0%; Peloton Interactive Inc: ITOT: 0.01%, AOK, AOM, AOR and AOA: 0.0%. For current fund holdings, please click on the tickers under the "Related iShares Funds" section above.
5 Source: Morningstar as of 5/31/2022. The S&P 1500 Energy index underperformed all other S&P 1500 sector indexes in 2017, 2018, 2019, and 2020.
Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares Fund and BlackRock Fund prospectus pages. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
Diversification and asset allocation may not protect against market risk or loss of principal.
Specific companies or issuers are mentioned for educational purposes only and should not be deemed as a recommendation to buy or sell any securities. Any companies mentioned do not necessarily represent current or future holdings of any BlackRock products. For actual fund holdings, please visit the respective fund product pages.
Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
A fund's environmental, social and governance ("ESG") investment strategy limits the types and number of investment opportunities available to the fund and, as a result, the fund may underperform other funds that do not have an ESG focus. A fund's ESG investment strategy may result in the fund investing in securities or industry sectors that underperform the market as a whole or underperform other funds screened for ESG standards. In addition, companies selected by the index provider may not exhibit positive or favorable ESG characteristics.
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This post originally appeared on the iShares Market Insights.
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