The past week has been hard on investors—but it didn’t have to be. If your portfolio was reasonably diversified, the stock market’s plunge hasn’t been that awful for you.
After a decade of stocks returning an average of 13% a year and a 40-year boom in bonds, the once-sacrosanct notion of diversification has fallen by the wayside for many investors. Until this week, that is. The spread of the coronavirus delivered a 12% drop in the S&P 500 index (.SPX) in the week ended on Friday and, along with it, a healthy reminder of the importance of good asset allocation.
Granted, many investors can ride out this correction just fine. Rather than worrying about your 401(k), consider that your next contribution means you’re buying stock at lower prices. But this still is a good time for investors to take another look at how they are invested—and why.
Most 401(k) plans have target-date funds, which offer instant diversification, not just between stocks and bonds, but also within each of those broad categories, and also often include other asset classes, like real estate and commodities.
For do-it-yourself investors, fixed income is the first step in portfolio diversification. Bonds are no longer a one-stop shop for income and capital appreciation—both are pretty hard to come by; the 10-year U.S. Treasury closed on Thursday yielding less than 1.3%. But they still offer stability when stocks are swooning: The Bloomberg Barclay’s U.S. Aggregate Index is up 1% in the week that U.S. stocks plunged.
Bonds have more duration risk than they used to, according to a new report from GMO. That means they are more sensitive to interest rate changes, and if rates rise, stocks and bonds could fall together, just as they have risen together for four decades.
Although long-duration bond funds like the Pimco 25+ year Zero Coupon US Treasury exchange-traded fund (ZROZ) have performed the best lately with rates plunging, investors should stick with shorter or more intermediate-term high-quality bonds. The yield curve is flat again, so longer-term bonds aren’t paying much, and their prices could fall a lot if the Federal Reserve raises interest rates.
Stability is no small thing—the Vanguard Total Bond Market (BND) is up 1.1% in the week ended on Thursday—but investors looking for return can’t abandon stocks. Instead, look for better diversification within equities.
“Honestly, there’s no point in owning bonds,” says Jenny Harrington of Gilman Hill Asset Management in New Canaan, Conn. “I know I’m way out on a limb, but I also know it’s the right thing for my clients.” Instead, Harrington prefers dividend stocks for her clients. She also says the conventional wisdom that a balanced portfolio of 60% stocks and 40% bonds is no longer reasonable for retirees, now that bonds are yielding so little and offer no opportunity for growth. “A lot of people who want to be in bonds can’t afford to be,” she says.
Dividend payers have performed well in the past at delivering income and stabilizing portfolios. There’s some interest-rate risk here, though: If rates rise, higher borrowing costs for companies could lead to a cash crunch that forces them to cut dividends.
Chris Brightman of Research Affiliates agrees that elevating exposure to dividend stocks is reasonable for retirees seeking income. But he cautions that U.S. stocks in general are pricey and dividend payers may not post the returns in the future that they have in the past.
Investors should also own international stocks. The MSCI EAFE Index, which tracks stocks from developed countries, is down 7.1% in the same period as the S&P’s 12% fall. And emerging markets stocks, which have not run up nearly as much as U.S. and other developed-nation stocks, fell just 5.9%. International stocks, especially from emerging markets, are meaningfully cheaper than U.S. stocks on metrics like dividend yield and the Shiller P/E (current price relative to the past decade’s worth of real average earnings). That means they might deliver better returns over the next decade, notes GMO and Research Affiliates.
Next, consider real estate investment trusts, or REITs. They’re not the outstanding diversifiers many make them out to be, and they tanked just as badly as the broader stock market in 2008. But their dividends are helpful, and they can hold up in times of inflation. Over the past few days, apartments, self-storage, and data-center REITs are down just 7% to 8%.
Then there’s gold—every bear’s best friend. Gold delivers no cash flow, but for millennia it has been considered a store of value, especially in unstable political times. Gold was initially up 4% while U.S. stocks were swooning, but those gains were cut as stocks showed hints of recovery on Friday.
Our model portfolios, consisting of global stock, domestic bond, Treasury inflation-protected securities, REITs, and gold, is our version of a traditional 60/40 allocation. Because the all-ETF portfolio includes an ETF that owns the actual metal, it performed better than the all-mutual-fund portfolio, but both lost about 5% from Feb. 19 through Feb. 27—markedly better than the 12% loss for the S&P 500.
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