RISK AND RETURN ARE related. That’s a truism that most investors know intellectually, but emotions around investing can be a drag on results. Stocks return more than bonds, but are more volatile. When equity markets flash sharp downside trading, as occurred recently, it’s easy to panic and sell in an attempt to reduce risk.
Unfortunately, such efforts often result in a different kind of risk: The chance you your investments will not generate the return you need to achieve your financial goals. In most cases, that goal is retirement, so the current portfolio needs to be designed to achieve just the right balance of growth and income to last as long as you do.
Even when markets tank, it’s wise to retain your predetermined allocation into equities. You continue to receive dividend payments, so it’s not a total wipeout; but even more important, your risk levels should be set to your long-term financial goals and not changed on a whim.
Allocate For Balance
While the connection between risk and return is clear, many investors overlook the role of diversification and, in particular, asset allocation.
In a sense, diversification is the easier concept to grasp: Don’t put all your eggs in one basket. But in practice, that advice is more complicated. How do you know which baskets to use? Do you have enough in any given basket? Too much? Do you have the right eggs in each? Do all these baskets even belong there?
You can implement portfolio diversification through asset allocation. That simply means deciding which types of investments, or assets, belong in your portfolio, and in what amounts.
For example, say your financial plan calls for an allocation that consists of 60% stocks and 40% bonds. At first, that may seem instructive, but on deeper analysis, it doesn’t give you much to go on.
Start with a look at the different equity asset classes. When Americans think of stocks, they generally think of the S&P 500 and its biggest components, such as Microsoft Corp. (ticker: MSFT), Apple (AAPL), Facebook (FB) or Alphabet (GOOG, GOOGL). But the S&P 500 only represents one asset class: large U.S. stocks.
However, even an investor who owns an exchange-traded fund tracking that index is more diversified than someone who holds 10 single stocks. The S&P 500 consists of 11 sectors: communication services, consumer discretionary, consumer staples, energy, financials, health care, industrials, materials, real estate, technology and utilities.
Immediately, it’s clear why an index fund is more diversified than owning a relatively small number of stocks.
Wise Choices For Diversity
However, true asset allocation doesn’t stop there. It’s important to invest beyond just large domestic stocks. How about small-cap domestic stocks? These are stocks with a market capitalization between$300 million and $2 billion. Small-cap stocks are typically more volatile than their larger peers, but also return more over time.
What about non-U.S. equity asset classes? Here again, it’s important to have the right kinds of stocks in your portfolio. You want large and small stocks from developed nations, which include European Union countries, Japan, Canada and Australia, among others.
Emerging-market stocks are another asset class. These are companies domiciled in nations whose financial markets or banking systems are not as established, stable or well regulated as those in developed nations. Emerging-market stocks deliver a higher return, but that comes at a price: higher risk.
You don’t need to load up your portfolio with these high-risk investments, but having some exposure can add some juice to your return. However, be prepared for periods of time when emerging-market stocks underperform. For example, over the past decade, as U.S. large stocks have been on fire, emerging markets lagged. In the previous decade, the reverse was true.
Asset allocation is also important on the bond side, where short-term bonds with high credit quality will dampen the volatility of stocks. The percentage of bonds you need comes back to your financial plan. What risk levels should you be taking to generate the return you need?
Asset allocation involves much more than guesswork and throwing together a few securities and declaring yourself “diversified.” It all stems from your investment philosophy and your plan, and should not be subject to whim as the equity and bond markets ebb and flow.