During the bear markets of 2000-2002 and 2007-2009, the S&P 500 Index lost 49.1% and 56.4%, respectively. As a result, it's estimated that investors lost trillions of dollars during those two downturns.

In many cases, investors suffered larger losses than necessary due to their failure to effectively diversify their investment accounts. Many investors mistakenly believe they have diversified by simply choosing investments from a number of different asset classes. However, diversification involves much more than combining a couple of large-cap, small-cap, growth, value, and international mutual funds.

Seven glass jars filled with coins

Image source: Getty Images.

The goal of diversification is to combine funds that behave differently under similar market conditions, giving you greater downside protection against major financial losses. In order to diversify effectively, investors need to consider the correlation of returns between each investment in their portfolios and the extent to which their performances track each other. The greater the correlation of returns, the less diversification provided by the two investments.

The correlation of returns between two investments is the extent to which the two investments' returns track each other. Where the investments' returns are extremely similar, those investments are said to be highly correlated and tend to react similarly to market conditions. And therein lies the problem with owning a collection of highly correlated investments: They fail to provide the potential downside protection most investors want.

Studies have shown that investment accounts today are dominated by equity-based mutual funds, both domestic and international. The problem with such an allocation is that, over the past decade or so, the correlation of returns between equity-based mutual funds in general has risen, thus denying investors the downside protection they're looking for.

Bonds are commonly used to diversify an investment portfolio. This usually results in lower returns and lower portfolio risk than an undiversified portfolio of highly correlated equity-based investments, at least during bull markets. However, history has proven that the market is cyclical, and diversification is aimed at preventing significant losses during downturns.

The importance of avoiding significant investment losses cannot be overstated. The cyclical nature of the market means that it will eventually recover and provide an opportunity for investors to recover any losses they suffered during downturns. What many investors fail to realize, however, is that the returns required to fully recover from losses will always be greater than the amount of the original loss, as the investor will be starting with a lower amount in the account.

Original LossReturn Required for 100% Recovery
10% 11%
20% 25%
30% 42%
40% 67%
50% 100%

It should also be noted that the time spent recovering from losses represents an opportunity cost for investors, because any capital gains that could otherwise enhance the value of their portfolios (and thus accelerate their compound interest) will instead go toward making up lost ground.

It's up to you to diversify your holdings

On a final note, most 401(k) and 403(b) retirement plans, sadly, do not offer investment choices that would allow participants to effectively diversify their retirement accounts. This has resulted in numerous lawsuits against 401(k) and 403(b) plans. Furthermore, the Employee Retirement Income Security Act of 1974 -- the law that governs most retirement plans -- does not require that plan participants receive correlation data on the investment options in their retirement plans.

If you'd like to see how your investments correlate to other investments or major benchmarks, then you could try this simple online calculator or this more customizable alternative. The closer two investments' correlation is to 1, the more similar their performance is likely to be. If it turns out your investments have a dangerously high correlation, then consider changing your allocation. If your employer-sponsored retirement plan doesn't offer sufficiently varied investments, then it may be a good idea to direct more of your savings into an account with more options, such as an IRA.

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