CalPERS 457 Deferred Compensation Plan

Reducing Risk through Diversification

You're planning a visit to San Francisco. What do you pack? Suntan lotion or an umbrella? You do a little research. You check the weather forecast. But even though the prediction calls for sunshine and warm temperatures, you bring along the umbrella and rain gear just in case. Your suitcase may be heavier, but you'll be prepared, rain or shine!

This principle of covering your bases holds true with your investment portfolio, as well. Most investors avoid putting all of their money into one investment. Too risky. A well-balanced portfolio will consist of different asset classes and a variety of investments within each asset class. That's diversification.

Smooth out the ups and downs
Since different investments tend to rise and fall in value at different times and for different reasons, diversification can help smooth out the inevitable ups and downs of the markets. Diversification also helps to reduce risk. By distributing your money across different asset classes and investments, you reduce the risk of being hurt by poor performance in any one particular investment.

You might be wondering how high are the peaks and how low are the valleys if you were not to diversify but invest in exclusively one asset class. The chart below illustrates how the asset classes have fluctuated and the average return over the last 30 years.

Asset ClassReturnBest / YearWorst / Year
Stocks12.17%37.57% / 1995-36.99% / 2008
Bonds8.88%32.62% / 1982-2.92% / 1994
Short Term Investments5.52%14.01% / 19810.21% / 2009

Source: Standard & Poor's The chart returns above are based on historic performance of market indices for the period 1/1/1980-12/31/2009 and do not represent performance of any specific investment funds. Stocks are represented by the total returns of the S&P 500, unmanaged index generally considered representative of the U.S. stock market. Bonds are represented by the Barclays Aggregate index, a broad based index maintained by Barclay’s Capital often used to represent high grade government and corporate US bonds. Short-Term Investments are represented by a composite of the yields of 3-month Treasury bills, published by the Federal Reserve, and the Barclays 3-Month Treasury Bills index, a market value-weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury.

When you diversify, you spread your investment dollars among a variety of investment classes. This strategy helps to smooth out your total portfolio performance: the good performance of some investments may offset the not-so-good performance of others.

What's the flip side? If you have some stellar performers in your portfolio, your total return may be weakened by poorer performing investments. As you can see, reducing the risk of investment losses also means giving up some of your potential gains. But when you consider how much you could lose when you lump your money into just a single investment, especially during volatile times when the market drops significantly, you may be willing to accept more "middle-of-the-road" returns in exchange for the relative stability which diversification offers. Regardless of the type of investment you have, it is likely to be affected by what's happening in the major markets as well as overall economic factors such as interest rates, the growth rate of the economy, the inflation rate and unemployment.

You should consider diversifying among a variety of asset classes as well as among a variety of investment strategies. This includes the types of securities the fund invests in (large company stocks, foreign stocks, government bonds, etc.), the particular investing style the fund manager uses, such as growth investing or value investing, and specific techniques the manager uses to select securities. You may find that certain investing styles fit in with your philosophy better than others.

As it relates to investing styles, the "strategy" is the basic philosophy or investment approach used by a fund's portfolio manager. Because every portfolio manager is different, investment styles vary from one fund to the next - sometimes subtly and sometimes dramatically. Just as it's important to diversify your investments among asset categories such as stocks, bonds and cash equivalents, it's also important to diversify by investment management strategies. Doing so will help you take diversification to a higher level, and may also help you to maximize returns while minimizing risk.

To learn more about the different investment strategies, access the following links below:
Diversification and asset allocation
It's important to make a distinction between diversification and asset allocation. Asset allocation is the percentage of your total account value in each asset class / stocks, bonds, and short-term investments. Diversification is spreading your money across many different investments, either within a particular asset class (large company stocks, mid-sized company stocks, small company stocks, etc.) or among various asset classes. So it's possible to have a diversified portfolio that is 100% invested in stocks.

At first, you might be confused more about the concepts of diversification and asset allocation, so you may want to review them in greater detail. This site is one of many tools available to help you learn about diversification. You can supplement the information provided with other sources such as personal investment magazines and books, the financial section of local and national newspapers, and commercial websites. A consultation with a financial planner may be necessary to determine what is right for you.

Using Diversification/Asset allocation as part of your investment strategy neither assures nor guarantees better performance and cannot protect against losses in declining markets.