One of the most important lessons the stock market has taught us over the years is that asset classes, often unpredictably, move in and out of favor. One year small cap stocks might lead the way. The next year municipal bonds or emerging market stocks might soar. Because global markets, economic fundamentals, and investor sentiment are constantly in flux, no single asset class consistently outperforms. Attempting to forecast these asset class performance shifts, however, is a strategy that typically proves about as successful as trying to time the market. In all likelihood, it will probably leave you further from your investment goals than when you began. So, why not give up trying and enjoy the fruits of your hard work now, rather than spending years to save and invest for an unknown future? How can you possibly protect your portfolio from market and asset class volatility? You can certainly avoid market risk by simply not investing. But there are a host of other risks such as inflation and outliving your assets (often referred to as longevity risk), which can cause you far more financial harm. Long-term investing is the tried and true engine that offers potential to both grow and preserve your wealth for current and future generations. And, the way to accomplish that most effectively is by using asset allocation and diversification to help minimize your risk.
Annual returns for various asset classes (1998-2017)
The difference between asset allocation and diversification
Asset allocation and diversification aren’t necessarily the same thing. Asset allocation describes the ratio of stocks, bonds and cash in your portfolio and is the primary determinant of investment risk and performance. Diversification, however, involves the spreading out of your investments within each of these major asset classes. For example, given your age and risk tolerance a portfolio that’s 60% stocks, 30% bonds and 10% cash may be appropriately allocated. But if the 60% stock component is made up solely of large cap U.S. tech stocks without broad exposure to other sectors (e.g., consumer cyclicals, financials, utilities, etc.), regions (e.g., international and emerging markets), and market caps, then it’s not well-diversified. Regardless of how your portfolio is allocated, the more diversified your holdings are within each of those allocations, the less volatile and more predictable your returns should be. Diversification does involve a trade-off, however. You aren’t going to match the returns of the top performing asset class each year. But on the other hand, you’re likely to significantly outpace the worst performing asset class—particularly during negative stock market years.
Don’t benchmark a diversified portfolio against the S&P 500®
It’s the index we see and hear about the most. The media loves focusing on it. But the S&P 500 represents just one part of a diversified portfolio (large cap U.S. stocks). When stocks are soaring, it may feel a bit frustrating to see your portfolio lagging the index. But you’ll feel a whole lot better during those times when the stock market is down 20% and your portfolio is only down 8%.
The case for diversifying overseas
Many investors tend to avoid international and emerging markets because they don’t have the same comfort level and familiarity with foreign companies and markets that they have with domestic companies. You may see headlines about political and economic instability or terror attacks, and naturally feel hesitant about taking on what seems an unnecessary risk considering how strong domestic returns have been for so long. Yet, the case for diversifying your portfolio with foreign stocks is a compelling one.
While still quite large, the role of the U.S. in the global economy is steadily becoming smaller. Today, 96% of the world’s population and three-quarters of the world’s corporations exist outside of our borders. And although U.S. businesses still generate 25% of the world’s GDP, that percentage is expected to continue growing smaller.
How can you go about more effectively diversifying your portfolio? Until fairly recently, investing in international and emerging markets was prohibitively expensive. Now, however, thanks to the wide range of no-load mutual funds and exchange traded funds (ETFs), you’re able to invest in hundreds of securities all at once, without any significant transaction fees. There are also a host of market index funds (e.g., commodity index funds, real estate investment trust (REIT) index funds, fixed-income funds, etc.) that can offer additional asset allocation benefits as well as broad diversification within those asset classes.
Staying the course
Don’t give in to short-term fear and let it derail your long-term goals. Rather than fretting over day-to-day market swings, focus instead on working with your BLB&B advisor to make sure you have an investment portfolio designed to address both your short-term needs and long-term goals. Over long periods of time, well-diversified portfolios are designed to deliver competitive returns while avoiding the excessive asset class swings that can hamper long-term results.
Heed the guidance of Warren Buffet who famously stated, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” Market volatility will come, and market volatility will go. For owners of well-constructed portfolios, however, riding out the inevitable periods of turbulence is quite often the optimal course of action to take.
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