This chart perfectly sums up why it's important to have a diverse investment portfolio
If you're thinking about investing some of your money, or if you already do invest, you've probably heard about the importance of being properly diversified, which is critical to building long-term wealth.
In simple terms, having a diversified portfolio means your money is invested in different types of assets, like stocks and bonds, rather than putting it all in one place. Having a balanced portfolio reduces your overall risk. When stocks fall, bond prices tend to rise, and vice versa, so it's good to have some of both to lessen your chances of losing money if the market tanks.
What a lot of people don't realize is that "there's a lot more than just stocks and bonds out there," Ric Edelman, founder of Edelman Financial Engines and author of "The Long-Term Financial Impact of Covid-19," tells CNBC Make It.
Stocks and bonds are broad categories that encompass several asset classes. There are large-cap, mid-cap and small-cap stocks, and government, corporate and mortgage bonds, for example. You want to own a mix since one asset class might overperform one year but underperform the next. The more diversified you are, the lower your risk of losing a lot of money at once since they will ideally balance each other out.
Take a look at this chart from Edelman's report, which shows the performance of 16 major asset classes over the past 10 years. Each color represents a different asset class.
As the chart shows, there's no clear pattern of how an asset class will perform best year after year.
"Performance is random," Edelman writes in the report.
It's nearly impossible to pick and choose which ones will be top performers at any given time. "If you had invested in each of these 16 asset classes and market sectors equally over the past 15 years, your return would have been 8% per year," Edelman writes. "But if you had missed the top three each year, your return would have been only 4% per year."
While one particular investment may outperform others one year that doesn't mean it will continue to do better than others over the long-term. "Nobody knows what the best performers are going to be next year," Edelman writes. "Therefore, the only way you can hope to capture the returns of the markets is to be invested in all of them all of the time."
A simple way to invest across a broad variety of assets is through passive investments, like low-cost index funds or exchange traded funds (ETFs). (Read more about how to invest in index funds.)
While having a diversified portfolio is always important, it's especially important during times of uncertainty like right now, in the middle of a pandemic. "The fact that no effective treatment, cure or vaccine yet exists and that most companies will continue to experience a decline in profits until most Americans are again employed and feel safe to congregate, we must acknowledge the possibility that stock prices will fall," Edeman writes in the report. "A disciplined investment approach is more important than ever."
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