Building a Resilient Portfolio: The Case for Diversification

Diversification involves spreading investments across a variety of securities or asset classes—but why is it important?

Consider a two-stock portfolio consisting of Delta Air Lines and Exxon Mobil Corp. When oil prices rise, Exxon may perform well as it profits with the rise in the price of crude oil. However, Delta may suffer as higher jet fuel prices compress its margins. Conversely, if oil prices decline, Delta’s margins are likely to improve, while Exxon could feel the pinch. Because these two stocks are uncorrelated, holding both helps smooth the portfolio’s overall risk. Instead of experiencing a 40% decline due to falling oil prices, gains from Delta may help offset the losses in Exxon.

In a broader equity portfolio, investors can diversify among U.S. and international stocks, large-cap and small-cap companies, growth and value styles, and various sectors—because not all equities move in lockstep. Ultimately, whether investing in a fund that tracks the S&P 500 Index or building a custom diversified portfolio, an investor might still achieve a long-term average return of around 10%. However, owning a mix of assets across sectors, asset classes, and geographies can help smooth out year-to-year volatility.

When investors see back-to-back years of 20% growth in the S&P 500, they often question the need for diversification. However, building a truly diversified portfolio requires looking back 40 to 50 years to identify historical returns and uncover uncorrelated assets that can work together to optimize returns relative to risk. It also requires considering one’s long-term financial plan. Even if investors are confident in large-cap equity performance over the next two to three years, how confident are they over a 30-year horizon?

If a financial plan shows that an investor needs to earn an average return of 10% over the next 30 years to meet their goals, our job as investment advisers is to find the least risky way to achieve that return. Chasing allocations that promise 30% returns can lead to excessive risk-taking and increased downside potential. With higher volatility, behavioral challenges arise—investors may panic and sell during downturns, locking in losses and potentially missing the recovery.

What about fixed income as a diversification tool? While bonds and other fixed-income investments can provide diversification, we adhere to the Henssler Ten Year Rule by allocating only the funds required within the next 10 years to fixed income. Long-term money remains invested in equities for growth. Equity portfolios can range from conservative strategies focused on dividend-paying stocks to aggressive allocations, including small- and mid-cap companies and international exposure.

It’s easy to believe in U.S. exceptionalism and assume our stock market will continue outperforming. We’ve experienced a prolonged period of dollar strength. However, the future impact of aggressive tariff policies, rising inflation, expanding deficits, and tax policy changes remains uncertain—and could threaten our standing as the world’s reserve currency. Another recession, like the Financial Crisis (-53%), the Tech Bubble (-31%), or the 1970s stagflation (-38%), is always a possibility. Diversification can help reduce the impact of such downturns over rolling 10-year periods so equity portfolios don’t suffer as severely.

If you have questions on diversification and the level of risk in your portfolio, the experts at Henssler Financial will be glad to help: