Do Asset Allocation and Diversification Still Work?
January 27, 2016
Here we go again. Just when we thought we could put the worries of 2008 and its aftermath behind us, market volatility once again has individual investors spooked and wondering what to do. While every investor knows that risk comes with the territory, the recent wild gyrations are enough to make even the hardiest investors question their approach.
So it comes as no surprise that I’m getting a lot of questions about how to protect a portfolio. People understandably want to know if the standard thinking has changed, and if so, how. The good news is that even though some points of execution have been fine-tuned, the fundamental principles of asset allocation and diversification remain the best ways to control risk. Let’s take a look.
Asset allocation and diversification still best for risk control
Asset allocation and diversification seem pretty similar and a lot of folks confuse the two, but they're actually quite different. The key to creating a lower-risk portfolio is to understand that difference and how the two work together.
Asset allocation is the way you divide your money among stocks, bonds, cash and other investments. This division into the various asset classes should be based on how much risk you're willing to take and how soon you'll need your money. Stocks carry the highest risk, cash the lowest, and bonds/fixed income are somewhere in between. Any money you'll need within the next three to five years should be kept in lower risk investments.
The use of asset allocation as a way to manage risk was first introduced in the 1950s as Modern Portfolio Theory. This theory basically proposed that rather than judging risk by looking at an individual investment, you need to look at how all the investments in your portfolio work together. By choosing a variety of investments that react differently to market conditions—those described as having a low correlation to each other—an investor could reduce overall risk.
Diversification takes this a step further. It spreads your money around different types of investments within each asset class. For instance, instead of one stock or bond, ideally you would have many of each. Dividing even further, you want to have different types of stocks, such as large cap, small cap and international. And within those divisions, it may be best to have stocks in different sectors (i.e., technology, healthcare, telecommunications) and different industries within the sectors. Your ultimate goal is to find investments that don’t move in lock-step with one another. That way, when one investment goes through a rough patch, another will hopefully compensate.
You might say that asset allocation lays the foundation for the structure of your portfolio, and diversification fills it in. With the two working together, you have greater exposure to investments that ideally will perform differently under various markets conditions—one may go up when the other goes down—and balance your risk.
Adapting to changing market realities
But we live in a far from ideal world. Since the 2008 financial crisis, there's been a much higher correlation between asset classes. Anticipated returns from stocks and bonds are both lower. Globalization has meant that markets are more susceptible to external shocks—not only financial but also political and environmental. And investors are more wary. As a result, updated portfolio advice, while still built upon asset allocation and diversification, focuses more on downside risk with the goal of giving you the greatest return for the least risk. This means that there are some further refinements that today's investor needs to consider.
Finding your target asset mix
As I mentioned before, the appropriate basic mix of asset classes depends on your feelings about risk and how long you plan to keep your money in the market. Traditionally, an aggressive investor with a long time horizon and a high risk tolerance might have as much as 90 percent of a portfolio in stocks with 10 percent in cash; a moderate investor could have perhaps 60 percent stocks and 40 percent bonds and cash; a conservative investor could pare that back to 20 percent stocks and 80 percent bonds and cash. Of course, the more aggressive the portfolio, the greater the risk.
Those broad categories still hold, but what's evolved is the fine-tuning possible within them. Individual investors now have access to what are considered "non-traditional" asset classes that can offer even greater diversification. These include things like real estate investment trusts (REITs), commodities (i.e., energy, agriculture, precious metals), Treasury Inflation Protected Securities (TIPS) and international bonds among others. These non-traditional asset classes have low correlation to traditional asset classes—they move differently in different markets—so adding them to your portfolio can potentially lower your investment risk.
How to stay on top of it all
An appropriate asset allocation and a long-term view are still fundamental to mitigating risk and protecting your portfolio, but that doesn't mean you should invest and forget.
While it's never smart (and rarely successful) to try to time the market, you can take advantage of market opportunities or attempt to avoid risk by tactically changing your asset mix within a certain range. It’s important to note, however, that this doesn’t mean that you would move in and out of the market all together, but rather making subtle shifts to respond to changing market conditions. For instance, if your current equity allocation is 40 percent, you may choose to underweight or overweight by a small percentage, depending on the markets. At the very least, you should be reviewing your portfolio quarterly and rebalancing yearly to stay within your target asset allocation.
There's a lot to think about, but bottom line, yes, asset allocation and diversification are still essential for protecting your portfolio. But to make yourself feel even more secure, it would be a good idea to check in with your financial advisor and discuss adjustments you might make in light of our current financial realities.
Asset allocation and diversification cannot ensure a profit or eliminate the risk of investment losses.