INVESTOR PLUS

Maintaining Maximum Growth PotentialMaintaining Maximum Growth Potential

History provides a powerful reason for you to establish and maintain an allocation to stocks and bonds that is appropriate for your financial goals.

An Annual Review of Your Financesnvestors today may be concerned about the prospects for both stocks and bonds. Since 2000, the stock market has suffered two of the largest bear markets on record, prompting some investors to pull money out of equities. The bond market reveals a different story: Strong performance from 2007 through 2012—and more than a trillion dollars in assets flowing into bond funds*—have led to predictions about a bubble in the bond market.

These concerns have caused some investors to forget a fundamental lesson of market history: Sustaining diversified exposure to both stocks and bonds, in proportions appropriate to the investor's time horizon and personal circumstances, provides strong potential for investment success.

FOCUS ON THE LONG TERM

The short-term factors affecting stock prices can be difficult to determine. Over the long term, however, stock investing has provided a way for individuals to share in the growth of the world economy as technologies have improved and resources have been better allocated.

Consider the returns of a $100,000 investment in the Barclays U.S. Aggregate Bond Index versus the S&P 500 Index over the past 20 years. If the assets had been invested in an all-bond portfolio, the value would have grown to $328,000. If it had been in all stocks, on the other hand, the account would be worth almost $200,000 more, or $514,000.

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LET HISTORY BE YOUR GUIDE

To better understand the decrease in market risk over longer time periods, consider historical performance. Of course, past performance cannot guarantee future results; however, if we examine the S&P 500 Index from the beginning of 1926 to December 31, 2012:

  • There have been 78 rolling 10-year periods since the beginning of 1926. The S&P 500 produced gains in 74 of them and losses in four—meaning the market gained ground in almost 95% of 10-year time frames.
  • Stocks produced positive returns in every 20-year period since 1926.
  • During the 58 30-year periods since 1926, the stock market's weakest performance was an annualized return of 8.5%.

These historical returns show that stocks have had a distinct advantage over other asset classes in producing long-term growth. That said, there also are important reasons to hold bonds.

If you have short- or intermediate-term goals, you can manage the risk of near-term losses by adding bonds to your portfolio. Bonds offer greater return potential than cash and greater stability than stocks, which is important for investors with near-term financial goals. The bond market declined during only nine of the past 87 calendar years, or about 10% of the time, and produced gains during every period of three years or longer since 1926.

BUILD YOUR PORTFOLIO

The appropriate allocation for your portfolio can help maximize your growth potential without exposing you to inappropriate levels of market risk for your time horizon. An investor who can wait 20 years or longer to begin drawing on his or her investments might consider pursuing growth through a portfolio largely of stocks. On the other hand, an investor who plans to start drawing on his or her investments within 10 years might consider a portfolio of 60% stocks, 30% bonds, and 10% short-term investments.

Your allocation should reflect your investment time horizon—the time remaining until you begin to withdraw the money and the amount of time it will take to spend it. The longer your time horizon in each case, the more you should hold in stock funds or other growth-oriented investments.

Once you have chosen an appropriate asset allocation that seeks to balance inflation and market risk, you can take steps to help manage business and sector risk. Business risk refers to the possibility that a particular company will encounter difficulties, leading to a stock price decline in a short period of time. Sector risk is the chance that negative factors could affect a particular industry or segment of the financial markets.

Assumes 7% annual return in a tax-advantaged account.
This chart is for illustrative purposes only and does not represent the performance of any specific security.

Business and sector risk can take many forms. Politics, economics, and even the weather can influence the day-to-day performance of a market sector or stock. You can help reduce these risks without giving up the potential for solid returns by spreading your investments among different market sectors and diversifying among a variety of stocks within those sectors. That way, your overall returns aren't heavily dependent on any single stock, industry, or sector. "In the stock market, you want to diversify between domestic and international stocks and also by capitalization size," says Judy Ward, CFP®, a senior financial planner with T. Rowe Price. "You also want to diversify your bond exposure between international and domestic securities—and bonds with different credit qualities and maturities." Remember that diversification cannot assure a profit or protect against loss in a declining market.

Whether you are developing your first investment plan or reviewing an existing one, avoid the temptation to time the market. History shows that attempting to do so can undermine an otherwise sound investment strategy. Research firm Dalbar, Inc., has found that equity fund investors' average returns consistently lag the market by wide margins, largely because investors tend to enter and exit the market at the wrong times. "It's very difficult to time the market," says Ward, who points out that market behavior is far too complex for anyone to anticipate. "Investors may get out of the market without a real sense or a plan of when they should get back in."

Consider that recoveries from downturns can happen quickly. In the rebounds from the last 15 bear markets (declines of roughly 20% or more), the S&P 500, on median average, recouped 30% of its losses in the first 49 days after the bottom. If you choose to sell equity holdings following a decline, you risk missing out on this powerful initial surge. Moreover, if you pull out of the market and happen to miss some of its best days, you may miss out on the recovery altogether. For example, a continuous investment in the stock market (as measured by the S&P 500) for the 10-year period ended March 31, 2013, would have returned 8.5%, annualized. But investors who had missed the 10 best days during that time would have fared significantly worse, with a 1.3% annualized return.

ADHERE TO A PLAN

Some investors question whether stocks and bonds will be as resilient as they have been in past decades. Their assumption that the market has now fundamentally changed is the same that other investors have made during past periods of considerable volatility or recession. In each instance, however, the market maintained its general upward trend. In all likelihood, stocks will continue to provide the greatest long-term growth potential, while bonds will offer a combination of relative stability and modest return potential. Explains Ward, "When managing your investments, look beyond the volatility of the moment and focus instead on adhering to your strategy—in particular, continuing to save and invest and maintaining an investment mix that is appropriate for your time horizon. These are the variables you can control—and they are the most likely to determine whether you succeed at reaching your investment goals." 

*Market data source: Morningstar, Inc., Ibbotson® SBBI® 2013 Classic Yearbook.

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