Do Asset Allocation and Diversification Still Work?

Dear Readers,

Here we go again. In early March, the COVID-19 pandemic brought the 11-year bull market to a crashing halt. Since that time, the markets have largely recovered but have been plagued with extreme volatility, leaving individual investors frightened and confused. While every investor knows that risk comes with the territory, the recent wild gyrations are enough to make even the hardiest investors feel unsure.

So it comes as no surprise that I’m getting a lot of questions about how to protect a portfolio. People want to know if the standard advice has changed. 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 the best investment strategy

Asset allocation and diversification seem pretty similar and a lot of folks confuse the two, but they're actually quite different. A key to creating a sound investment portfolio is to understand that difference and how the two work together.

Asset allocation is the way you divide your money among major investment categories like stocks, bonds, cash and other types of investments, some of which are riskier than others. Therefore, this division into the various asset classes should be based on how much risk you're comfortable taking and how soon you'll need your money.

While stocks have the highest return potential, they also carry the highest short-term risk. Cash, on the other hand, has the lowest return potential, but the least amount of short-term risk. Bonds are somewhere in between. Any money you'll need within the next three to five years should be kept in lower risk investments.

Asset allocation was first introduced as a way to manage risk in the 1950s. Research showed that a portfolio's overall risk and expected return was a result of how each underlying investment performed individually as well as how investments behaved together. By choosing a variety of investments that react differently to market conditions—or those that have a low correlation to each other—an investor could reduce overall risk.

Diversification takes this concept a step further by spreading your money between different types of investments within each asset class. For instance, instead of one stock or bond, ideally you would have many. Dividing even further, you should have different types of stocks, such as large cap, small cap and international.

And within those divisions, you can diversify further by investing in different sectors (i.e., technology, healthcare, telecommunications) and different industries within the sectors. In the case of bonds, you can diversify within government, government agency, corporate, international, and high yield (“junk”) bonds of different maturities. 

Your ultimate goal is to find investments that don’t move 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 your portfolio, and diversification builds the floors and rooms. With the two working together, you have greater opportunity for your investments to perform differently under various market conditions. One investment might go up when the other goes down—and balance your risk.

Adapting to changing market realities

So what, if anything, has changed? As first became apparent during the Great Recession of 2008, globalization has made markets more susceptible to external shocks, causing increased volatility and stronger correlations between asset classes. This surprised investors who had expected different asset classes they held to zig while others zagged and instead experienced that as asset classes zigged, the others would zig too—or zagged by a much smaller amount.

This doesn’t mean, however, that diversification and asset allocation didn’t work; they just didn’t provide the level of protection that one would have hoped for. If anything, this experience shows us that we need asset allocation and diversification more than ever. Market volatility only reinforces their importance.

The relatively new availability of low-cost "non-traditional" asset classes can help. Investments like real estate (real estate investment trusts or REITs), commodities (energy, agriculture, precious metals), Treasury Inflation Protected Securities (TIPS) and international bonds have historically had low correlation to traditional asset classes—moving differently in different markets—so adding small amounts to your portfolio can increase your diversification, potentially lowering your investment risk over time. The exact amount you use depends on your situation and investment preferences.

Diversification can’t always protect you against short term market declines, but it historically has been a great defense against long periods of poor returns which can be more destructive. It remains a great strategy.

How to stay on top of it all

But you can’t stop there. Once you've built your well-diversified portfolio, it's also essential to stay involved.

In general, it’s smart to review your portfolio and rebalance at least yearly to stay within your target mix of investments based on your risk tolerance and time horizon—but in times of extreme volatility, you might want to do this more frequently, perhaps quarterly. Alternatively, you can rebalance when your investments fall outside of 5 percent of your target allocation.

And while it's never a good idea to try to time the market, it can make sense for some investors to make small changes to their portfolio to attempt to either take advantage of market opportunities or minimize losses. This doesn’t mean that you'd move in and out of the market all together, but rather rebalance and make small shifts to respond to changing market conditions.

There's a lot to think about, yes, but bottom line, asset allocation and diversification remain essential tools for protecting your portfolio. The more broadly you diversify, perhaps with the addition of new types of investments, the more you can potentially reduce risk. If you need more help, talk to a financial advisor and discuss changes before you make any moves.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.