The Downside of Diversification

Having a well-diversified portfolio will help you avoid some of the biggest bumps the financial markets throw your way. Remember, though, that the calming impact of diversification works both ways -- which will sometimes leave you disappointed.

Nothing shows the benefits of diversification better than jittery markets. When one part of your portfolio is down, other investments rise in value, offsetting or even outweighing those losses. The goal of diversification is to provide smooth, steady growth to your portfolio, reducing the volatility that challenges the determination of even the best investors.

The challenge of diversification
Smooth, steady growth, however, isn't always as attractive as it might be right now. As you'll see in this month's issue of the Fool's Rule Your Retirement newsletter -- which will be available today at 4 p.m. ET -- having a diversified portfolio means there's always some investment you own that lags the others.

Consider, for instance, the technology boom of the late 1990s. Between October 1998 and March 2000, the Nasdaq index more than tripled, as stocks like Cisco Systems (Nasdaq: CSCO) and Sun Microsystems (Nasdaq: JAVA) benefited from the rise of the Internet.

Investors with diversified portfolios certainly enjoyed strong returns during those years. But they couldn't come close to the stellar performance of the Nasdaq. Over the same 18-month period, for instance, the S&P rose "only" 29%. Bonds barely broke even during 1999. And real estate investments lost nearly a quarter of their value during 1998 and 1999. The booming tech sector sent even the most conservative of investors scrambling to get into the next big Internet IPO.

Of course, we all remember what happened next. The Nasdaq crashed far harder than the rest of the market, ruining many investors who'd put big bets on the tech sector.

The latest big thing
This time around, commodities and materials stocks have taken the place of technology. Metals miner Freeport McMoRan Copper & Gold (NYSE: FCX) has nearly doubled in the past year, while Rio Tinto (NYSE: RTP) is up 125%. Booming prices for farm products has sent Monsanto (NYSE: MON) stock into the stratosphere, with a 120% gain in 12 months.

Meanwhile, traditional defensive plays haven't done nearly as well. Consumer stalwarts like Procter & Gamble (NYSE: PG) have dodged the market drop, but small returns don't compare favorably to commodities. And other defensive stocks, such as drugmaker Pfizer (NYSE: PFE), have lost money with the rest of the market.

Settling for success
It's tempting to put all your money into investments that are rising strongly. But to do so successfully requires not only identifying those investments early in their rise but also having excellent market timing in taking profits before the trend reverses itself. As Foolish retirement expert Robert Brokamp discusses in another Rule Your Retirement article this month, that kind of precision maneuvering is almost impossible to execute effectively.

Fortunately, you don't have to find the perfect investment in order to achieve financial success. While you may not get rich quick from a lucky stock pick, the steady growth that comes from a diversified portfolio will not only let you sleep better at night -- it'll help you reach all your dreams in time.