By Daniel Prince, Head of iShares product consulting for BlackRock’s US Wealth Advisory Business and US Head of iShares Core ETFs.

Daniel Prince.

Diversification is the practice of spreading risk and assets across sectors, industries, and companies. 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 ETFs starting in the 1990s.

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 did diversification and index funds do for investors this year?

Spreading the risk around

Benefits of diversification were apparent at the single-stock level. Investors were whipsawed by a steep, early-year decline tied to COVID, then a sharp rebound in US stocks, which climbed to new highs after Election Day. Through the end of November, the US stock market returned 16% but had been down for the year by as much as 32% in March.

Despite solid year-to-date gains of US stock indexes, the majority of single stocks fell. Only 47% of the constituents within the US stock market advanced, meaning the flip of a coin would have given investors a higher probability of getting it right. And stocks that fell, fell hard. Among the 53% of US stocks that declined this year, the average decline was 26%. In other words, if buying single stocks, it could have been easy to be a loser in a winning market.

Source: BlackRock.

Winners and losers

In an unpredictable year, the market leaderboard was filled with winners and losers for reasons that were unthinkable 12 months ago. Zoom Video Communications, operator of the now ubiquitous video conference software, surged more than 500%, giving the company a market capitalization larger than blue chips such as General Electric. Square, the payments company, jumped more than 200% on accelerated demand for cashless transactions.

On the flip side, relatively sound business models were delivered sudden shocks that impacted their stock performance. Shares of Simon Property Group, a developer and manager of shopping and entertainment properties, have slumped in the double-digits. Carnival, the cruise ship operator, likewise saw a severe decline in consumer demand and steep price declines.

The point is that successfully timing the market with individual securities — buying and selling at just the right times — is difficult even for the most experienced investor. Some index ETFs can hold the whole market, a strategy that helps shield investors from sharp declines of a few stocks. We recently conducted an analysis for professional investors that explains how broad, index-based strategies have helped investors pursue competitive performance over the long term.

Diversifying beyond stocks

Diversifying across many stocks is a good start, but most portfolios ought to be diversified across asset classes given all stocks have some sensitivity to common economic factors. Such asset allocations have everything to do with an investor’s goals, timeline, and risk tolerance, but in all cases iShares Core ETFs can help here as well. They seek to track widely recognized stock and bond market indexes, like the S&P Total Market Index (broad US equities) and Bloomberg Barclays US Aggregate Bond Index (broad US bonds), helping investors to track these markets at the center of their portfolio.

Consider the classic “60/40” portfolio, a blend of stocks and bonds that is commonly used as a proxy for the average person’s investment mix. This year, the mix would have worked well amid extraordinary volatility. Through November, a 60/40 blend of the S&P Total Market Index and the Bloomberg Barclays US Aggregate Bond Index would have gained 12.3% with less volatility than owning equities alone (see below).

Source: BlackRock.

Reupping on rebalancing

Beyond the sting of losing when single stocks fall hard, there is a risk that losses drive long-term investors away from their financial plan. And while it’s understandably uncomfortable to experience market declines, hasty decisions to exit the market — however briefly — can prove costly.

One potential solution is to “rebalance” portfolios at regular intervals to ensure that changes in the portfolio’s asset allocation are intentional. Consider that, after sharp stock declines amid COVID in the first quarter of 2020, as shown above, a 60/40 investor would have ended March with a mix closer to 50/50 — an even split between stocks and bonds.

With hindsight, that meant investors were less exposed to stocks than their tolerance suggested and were, therefore, less well-positioned to ride the broader market higher throughout the remainder of 2020. An investor who rebalanced back to 60/40 at the end of March 2020 could have added an additional 2 percentage points of performance by year-end merely by re-aligning allocations with one’s goals.

To be sure, it’s not always easy to rebalance in the face of uncertainty. That’s why iShares Core ETFs also offer asset allocation ETFs (comprised of individual iShares Core ETFs) that are designed to automatically rebalance for investors based on a specific level of risk.

Summing it up

Diversification helps investors to navigate fast-changing markets and stay the course to pursue their financial goals. This year offered a masterclass in how diversification through index-based ETFs could have helped the average investor avoid losing in a winning, albeit volatile, market. iShares Core ETFs can help investors diversify at both the stock and portfolio levels, and when rebalancing at regular intervals.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

DISCLOSURES