Importance of Diversification

We are often asked, "Where is the best place to invest?", "What is the hot stock to buy?" or “Mutual Fund A outperformed Mutual Fund B last year, should I sell Fund A and buy Fund B?"

Joshua P. Mersberger, CFP®, CRPC

Mar. 19th, 2019

A group of spices in bowls
A group of spices in bowls
Importance of Diversification

At Mersberger Financial Group, we often hear questions from clients and prospects about where the best place is to invest is or what is the hot stock to buy? We are also commonly asked, “Mutual Fund A outperformed Mutual Fund B last year, so should I sell Fund A and buy Fund B?

Our answer to these questions is that it is extremely hard to predict which stocks and/or market sectors will be the best performers from year to year. There is academic research that shows that active stock picking strategies often underperform the stock market and index funds in the long run. Owning the market and keeping costs low has the potential to lead to better performance in the long run.

The other issue with purchasing a specific stock or sector means you are only exposed to that stock or sector and if that area of the market is out of favor, you end up missing out on the performance of the market as a whole.

Diversification Definition

So what is diversification? At Mersberger Financial Group, we define diversification as owning asset classes that are not correlated to each other. Simply put, this means that our investments and investment strategies do not all perform the same when the market goes up or down. Over time, having investments that are not correlated should lead to better portfolio performance and lower volatility. This is why our firm continues to invest in international and emerging markets even though they have recently underperformed the US stock markets. While short term performance has suffered, it is important to look at long term performance and not overreact to several quarters or even years of underperformance.

Investment Strategy

Our advisors believe that a simplified investment strategy can lead to superior returns over time. While investing in a “hot stock” or great performing mutual fund may feel great in the short term, many times these strategies do not hold up over the long run.

A great example of this in recent history is Enron. This company was a long-time stock market favorites that lost most of its’ value. Enron had great performance and superior returns until it didn’t, and investors who had too much exposure and didn’t diversify were hurt as a result.

So, while an investment may look and sound great, it is critical to always remember the importance of diversification.

Have questions? Contact us.

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