nvestors have experienced signicant shifts in stocks and bonds over the past five years. Bonds came into favor in the years following the financial crisis that began in 2007, and as confidence grew in an eventual recovery, the stock market began its ascent. This year alone has seen extremes: The U.S. stock market started 2013 with strong performance that led indexes to record highs. But in June, concerns about signals by the Federal Reserve that it intended to reduce its stimulus efforts triggered a sell-off. Several weeks later, however, the Fed chairman confirmed a continuation of the stimulus efforts, which led to another rally and a new market high.
Seen from a long-term perspective, these sudden shifts in performance are transitory events—the inevitable result of the complex forces affecting markets—but they can have a greater impact on portfolios that are not well diversified. Establishing an appropriate mix of stocks, bonds, and short-term holdings is just the first step in managing market risks.
You also need diverse exposure within each asset class to increase your chances of reaching your goals. Holding a variety of investments also expands your ability to benefit from opportunities in the global economy, minimizes your exposure to risk in any one area, and reduces volatility in your portfolio. Of course, diversification cannot assure a profit or protect against loss in a declining market.
ESTABLISH THE PROPER ASSET ALLOCATION FOR YOUR GOALS
Your first step in constructing a well-diversified portfolio is establishing the appropriate mix of investments. Asset allocation is the single largest factor in determining the variability and magnitude of your portfolio's returns. For each of your financial goals, determine how to divide your assets among stocks, bonds, and short-term holdings, based on your time horizon and risk tolerance. (See Investing by Time Horizon.)
MEDIUM- AND LONG -TERM GOALS (THREE OR MORE YEARS) Savings should be allocated in favor of stocks to take advantage of the long-term growth potential of this asset class. From 1926 through 2012, stocks averaged a 9.8% annual gain, compared with an average annual return of 5.4% for bonds.1 As you get closer to achieving your goal, your allocation to stocks should decrease as you emphasize less volatile investments, such as bonds and short-term holdings.
SHORT-TERM GOALS (ZERO TO TWO YEARS) Savings should be held in stable assets, such as money market investments, that will help protect your portfolio from downside volatility. From 1926 through 2012, U.S. Treasuries have never experienced a two-year loss, while both stocks and bonds have seen two-year negative returns.
DIVERSIFY WITHIN ASSET CLASSES
Once you have established the appropriate asset allocation for a particular goal, you must ensure you are widely diversified within each asset class at the sub-asset class level. A recent T. Rowe Price study demonstrated the benefits of this concept. Of two portfolios with the same overall allocations to stocks and bonds, the portfolio with greater diversification within each asset class produced a 5.1% return from April 2000 through March 2013, compared with a 3.8% return for the less diversified portfolio. The portfolio with greater diversification also outperformed the basic portfolio in both bull markets that took place during that time period, as well as in one of the two bear markets. (See Diversification Can Improve Returns.) Past performance cannot guarantee future results.
There are a number of sub-asset class categories to consider—including sectors, geographic regions, and market capitalizations. To benefit as much as possible from diversification, you should seek exposure to a spectrum of options within these particular sub-asset classes:
Sectors and businesses. Broad exposure to an array of sectors limits the possibility that a downturn in any one industry might reduce the long-term growth potential of your portfolio. Owning stocks in a wide variety of companies can help to shield against business risk—the possibility that a company will have lower-than-expected profits, or a loss. Diversification at the sector and business level also helps to ensure that your portfolio will benefit if a particular sector or business performs strongly. Over the long term, diversification in these areas can help your portfolio withstand—and even benefit from—the economic cycle's impact on various industries.
Regions. Exposure to multiple regions can also put your portfolio in a position to benefit from those economies that are performing well.
INTERNATIONAL STOCKS The globalization of markets has prompted investors to shift their attention farther afield as they look to diversify their holdings. The reason: Not all regions respond to economic conditions in the same way. For example, emerging economies in Eastern Europe (excluding Russia) gained 25.6% in 2012, while Brazilian stocks lost 4.4%.2 In the U.S., the S&P 500 rose 13.0%.3
INTERNATIONAL BONDS The complexity and number of fixed income offerings has grown substantially in recent years—60% of global fixed income securities are now offered by countries other than the United States. Exposure to bonds in emerging markets can help increase a portfolio's yield compared with investing solely in domestic bonds. Meanwhile, exposure to bonds of other developed economies can help smooth any volatility that results from a U.S.-focused portfolio.
Diversifying across a number of regions also means you gain exposure to multiple currencies. This exposure can help diversify a portfolio away from a focus on the U.S. dollar, which can rise and fall due to an array of complex economic and policy factors both in the U.S. and in foreign markets. Keep in mind that international investments are subject to market risk, as well as risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad.
Capitalization. Holding stocks in small, medium, and large companies can help you find an appropriate balance between investment risk and potential return. Small-cap stocks generally are more volatile, with greater potential for growth, while companies with larger capitalizations offer greater stability and more measured growth expectations. Diversifying across the full range of capitalizations can help your portfolio benefit from shifts in business and economic cycles, which may favor different-sized companies at different points in time.
Bond types. In addition to government bonds from a variety of countries and regions, the bond portion of a portfolio might include corporate, high-yield, and international bonds. Investing in several bond investments with different investment strategies can help cushion the effects of interest rate risk and credit risk on your overall portfolio, a goal that can be achieved by investing in a diversified mutual fund.
INVESTING BY TIME HORIZON
Asset allocation and diversification for short-, medium-, and long-term purchase goals of different lengths depend on your time horizon and risk tolerance. Consider these goals, time horizons, asset allocations, and sub-asset categories.
* In the "Investing for Retirement" time line, the number zero shows an investor at age 65. Use this as a reference to find your age (10 to the left of zero shows you at age 55, 10 to the right shows you at age 75). The allocation chart above is based on age and does not take personal circumstances into account. An investment in a bank account or certificate of deposit may be FDIC insured.