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Transcript: Mission diversification

July 08, 2010

Narrator: As an investor, you hear all the time about the importance of diversification. So what makes it such a big deal?

Start by imagining your portfolio had just one stock—represented by the red ball. With stock in only one company, you're likely to experience big bounces both up and down.

If the company's sales forecast is better than expected, its stock may zoom higher. But if there's a setback, the stock can plunge.

If you diversify by adding more stocks, their individual ups and downs can help balance each other out so that you don't have such sharp ricochets. And if you go further with diversification by adding an investment that's less volatile you can smooth things out even more.

Here, the blue balls represent bonds, which historically have been less prone to big swings in value than stocks. So diversification is important because it can help you manage the risk that goes along with investing in stocks and bonds.

Diversification won't eliminate your risk of loss or guarantee a profit in a declining market. But it can reduce the chance you'll suffer disproportionate losses if one particular investment or sector falls sharply. And owning a broadly diversified portfolio gives you exposure to whatever the strongest performing sectors are at a given time.

How do you know what's the right level of diversification for you? A good way to get started on an answer is to consider long-term returns for different blends of stocks and bonds.

Here's an example of how a 50/50 mix of stocks and bonds, represented by broad averages, performed from 1926 to 2009. Over time, stocks have had higher average annual returns than bonds. In certain years, though, stocks have had far steeper losses than bonds.

To see how different asset mixes have performed in the past, you can adjust the percentage of stocks and bonds by moving the slider on the left.

Notes

  • Annual stock market returns are calculated using the Standard & Poor's 500 Index from 1926 through 1970, the Dow Jones Wilshire 5000 Index from 1971 through April 22, 2005, and the MSCI US Broad Market Index thereafter.
  • Annual bond market returns are calculated using the Standard & Poor's High Grade Corporate Index from 1926 through 1968, the Citigroup High Grade Index from 1969 through 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975, and the Barclays Capital U.S. Aggregate Bond Index thereafter.
  • All investments are subject to risk.
  • Diversification does not ensure a profit or protect against a loss in a declining market.
  • Investments in bonds and bond funds are subject to interest rate, credit, and inflation risk.
  • Past performance is not a guarantee of future results.
  • The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
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