Why DiversifyOctober 8, 2018
- A well-diversified portfolio begins with establishing an appropriate asset allocation.
- Choosing investments across sectors, sizes, and geographic regions can help manage portfolio volatility.
- Mutual funds offer a convenient path to building a diversified portfolio.
Varying forces and events contribute to the inevitable ups and downs in the market. And while no one can predict or control these fluctuations, you can control where you allocate your investments. Doing so can help ensure that your assets are invested appropriately for your age and financial goals.
ESTABLISH THE PROPER ASSET ALLOCATION FOR YOUR GOALS
Your first step in constructing a well-diversified portfolio is establishing an appropriate mix of investments. 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.
Long-terms goals (e.g., retirement)
Savings should have an appropriate allocation to stocks to take advantage of the long-term growth potential of this asset class. From 1926 through 2017, stocks averaged a 10.2% annual gain, compared with an average annual return of 5.1% for bonds.1 Past performance cannot guarantee future results. As you get closer to achieving your goal, the allocation to stocks should decrease as you emphasize less volatile investments, such as bonds and short-term holdings. (See “Asset Allocation for Retirement.”)
Short-term goals (e.g., emergency fund)
Savings should be held in stable assets, such as money market investments, that will help protect your portfolio from downside volatility.
Consider these retirement asset allocation models at different ages.
Within Equity: 60% U.S. Large-Cap, 25% Developed International, 10% U.S. Small-Cap, 5% Emerging Markets
Within Fixed Income: 70% U.S. Investment-Grade, 10% High Yield, 10% International, 10% Emerging Markets
Within Short Term: 100% Money Market Securities, Certificates of Deposit, Bank Accounts, and/or Short-Term Bonds
These allocations are age-based only and do not take risk tolerance into account. Our asset allocation models are designed to meet the needs of a hypothetical investor with an assumed retirement age of 65 and a withdrawal horizon of 30 years.
The model asset allocations are based upon analysis that seeks to balance long-term return potential with anticipated short-term volatility. The model reflects our view of appropriate levels of trade-off between potential return and short-term volatility for investors of certain ages or time frames. The longer the time frame for investing, the higher the allocation is to equities (and the higher the short-term volatility) versus fixed income or short-term investments.
While the asset allocation models have been designed with reasonable assumptions and methods, the chart provides models based on the needs of hypothetical investors only and has certain limitations:
- The models do not take into account individual circumstances or preferences and/or may not align with your accumulation time frame, withdrawal horizon, or view of the appropriate levels of trade-off between potential return and short-term volatility.
- Investing consistent with a model allocation does not protect against losses or guarantee future results.
Please be sure to take other assets, income, and investments into consideration when evaluating model allocations. Other T. Rowe Price educational tools or advice services use different assumptions and methods and may yield different outcomes.
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. Of course, diversification cannot assure a profit or protect against loss in a declining market.
There are many 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 the following:
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.
Exposure to multiple regions also can 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 (MSCI Emerging Markets Index) gained 37.8% in 2017, while Russian stocks (MSCI Russia Index) rose only 6.1%. In the U.S., the S&P 500 Index gained 21.8%.
- International bonds. The complexity and number of fixed income offerings has grown substantially in recent years—around 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, while exposure to bonds of other developed economies can help smooth any volatility that results from a U.S.-focused portfolio.
Note that international investments are subject to market risk, as well as risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad.
Small-cap stocks generally are more volatile, with greater potential for growth, while companies with larger capitalizations typically offer greater stability and more measured growth expectations. Diversifying across the full range of small, medium, and large companies can help your portfolio benefit from shifts in business and economic cycles, which may favor different-sized companies at different points in time.
The bond portion of a portfolio might include corporate, high yield, and international bonds as well as government bonds from a variety of countries and regions. Investing in several bond types 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.
Diversify Through Mutual Funds
A broadly diversified portfolio should include a variety of investments in three asset classes, depending on the time horizon of your goal and your risk tolerance. The challenge lies in achieving and maintaining this level of diversification throughout your portfolio and over time.
Mutual funds offer built-in diversification because they generally hold dozens to hundreds of investments aligned with a particular theme or goal. Furthermore, with actively managed funds, teams of investment professionals that include portfolio managers and analysts make decisions seeking to optimize the balance of holdings within the fund. These decisions are based on thorough analysis of market conditions and security valuations that may not be apparent without research, accessibility, and expertise. Investment teams decide how the holdings in the fund affect its overall balance.
KEEP YOUR PORTFOLIO BALANCED
To manage your overall investment portfolio on your own, look for sectors, geographic regions, and market capitalizations that are underrepresented in your portfolio. And be sure not to neglect diversification in the fixed income portion of your holdings. If you’re underweight in one category, you have too much exposure to another. Correcting this imbalance is important because it lowers your exposure to sectors that have risen comparatively in value and increases your exposure to those that have declined—and that action helps you maintain a portfolio that is properly allocated and diversified. Not only can rebalancing lock in gains, it will keep you well positioned to balance market risks with growth potential.
Market volatility is a constant for every investor. That’s why you need to maintain your investment strategy and remember the market’s record of long-term growth. Investing in a diverse mix of securities according to a purposeful asset allocation plan can help expand opportunities and minimize risks of overexposure to one particular area of the market.
1Sources: Stocks are represented by the Ibbotson SBBI U.S. Large-Cap Stock TR USD and bonds by returns of the IA SBBI U.S. IT Government TR USD.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. All investments are subject to market risk, including the possible loss of principal.
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