A masterclass in diversification

1. Recent stock market volatility has proven why diversification is important and can help reduce risk in portfolios.
2. Index funds can help all investors diversify at the single-stock and portfolio levels, including asset allocation ETFs.
3. Investors can consider using iShares Core ETFs to build a low cost, diversified portfolio as they pursue their long-term investing goals.

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 allow 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.

Despite this wild ride, over the last five years, patient investors have been rewarded as U.S. stock indexes have risen over 50%.² But, while the market has gone up, not all stocks have been a good investment. 31% 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 chance 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 51%.² In other words, almost a third of 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

5-year returns as of 10/31/2023

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.³ 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 outperformed the market by a whopping 81.5% in 2022. In 2023, tech benefitted from the boom in AI companies while energy reversed in performance given weaker global growth.⁴

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.