There are two moments when checking on the value of your investments and portfolio may be almost irresistible: when the market is roaring ahead—and when it’s tanking. But that’s just when emotions have a nasty way of clouding the minds of even the most seasoned investors.
It is better to take the time to set a long-term mix of stocks, bonds, and other investments according to your goals, time horizon, and risk tolerance. Then make a regular checkup a normal part of a disciplined investment process. At the very least, you should check your mix, known as your asset allocation, once a year or if your financial circumstances change significantly—for instance, if you lose your job or get a big bonus.
We believe that setting—and maintaining—your strategic asset allocation are among the most important ingredients in your long-term investment success. No matter what your age or goals, we believe this means being diversified both among and within different types of stocks, bonds, and other investments.
The goal of diversification is not to boost performance—it won’t ensure gains or guarantee against losses—but it can help set the appropriate level of risk for an investor’s time horizon, financial goals, and tolerance for portfolio volatility. At the heart of diversification lies the concept of correlation. Simply put, correlation is a measure of how the returns of two investments move together, i.e., whether their returns move in the same or in opposite directions, and how often. Correlation is a number from –1 to 1 that is computed using historical returns. A correlation of 0.5 between two stocks, for example, means that in the past when the return on one stock was going up, then about 50% of the time the return on the other stock was going up, too. A correlation of –0.7 tells you that historically 70% of the time they were moving in opposite directions—one stock was going up and the other was going down.
When you put assets that have low correlations together in a portfolio, you may be able to get more return while taking on the same level of risk, or the same returns with less risk. The less correlated the assets are in your portfolio, the more efficient the trade-off between risk and return.
To build a diversified portfolio, an investor should look for assets whose returns haven’t historically moved in the same direction, and, ideally, assets whose returns move in the opposite direction. This way, even if a portion of your portfolio is declining, the rest of your portfolio is designed to be growing. Thus, you can potentially offset the impact of poor market performance on your overall portfolio.
Another important aspect of building a well-diversified portfolio is that you try to stay diversified within each type of investment.
Within your individual stock holdings, beware of overconcentration in a single stock. For example, you may not want one stock to make up more than 5% of your stock portfolio. We also believe it’s smart to diversify across stocks by capitalization (small, mid-, and large caps), sectors, and geography. Again, not all caps, sectors, and regions prosper at the same time, so you may be able to reduce portfolio risk by spreading your assets out. If you are investing in funds, you may want to consider a mix of styles, such as growth at a reasonable price, quality growth, and aggressive growth.
Similarly, if you need to increase your bond allocation, consider bonds with varying maturities, styles, and sensitivity to inflation and interest rate changes. (If you are making changes to your portfolio, keep in mind that in cases where a sale is required, there may be tax consequences and you may realize a loss.)
If you are investing in funds, you will want to consider whether they have been strong, consistent performers relative to their stated objectives and styles. So read the fine print in the prospectus, or speak to your investment consultant. That way you can have a higher level of confidence that you are staying properly diversified.
Of course, just because your investments haven’t been historically correlated when you choose them doesn’t mean they will stay that way. Correlation can change dramatically and rapidly in volatile markets. Assets can become highly correlated, meaning their returns move in the same direction. This reduces the short-term benefit of diversification, which is what happened during the bear market downturn of 2008–2009, but it doesn’t reduce the long-term appeal of diversification.
A deeper look at the last bear market
During the 2008–09 bear market, the correlations of U.S. stocks to virtually every type of asset except Treasury bonds increased sharply. As the chart below shows, the correlations of U.S. stocks to international stocks and high-yield bonds jumped to nearly 90%. Investment-grade bonds and cash went from being negatively correlated to U.S. stocks to being positively correlated. All this reduced the effectiveness of diversification during this period.
Diversification has not failed
While it may have felt as though diversification failed during the downturn, it didn’t. The major asset classes have not been perfectly correlated, only more highly correlated. There’s a difference—it means that diversification still helped contain portfolio losses, but the benefit was lower than before the market decline.
Consider the performance of three hypothetical portfolios: a diversified portfolio of 70% stocks, 25% bonds, and 5% short-term investments; a 100% stock portfolio; and an all-cash portfolio.
By the end of February 2009, both the all-stock and diversified portfolios would have declined. The all-stock portfolio would have lost just more than half of its initial value (50.1%); however, the diversified portfolio would have lost just under a third (32.4%). Yes, the diversified portfolio would have declined, but diversification would have helped reduce losses compared with the all-stock portfolio. The all-cash portfolio (1.6%) would have outperformed the all-stock and diversified portfolios over this 14-month period. While short-term investments performed well compared with stocks, investing in all cash can limit the future growth opportunities of a portfolio, so it may not be an effective long-term strategy.
Watching the value of a stock or diversified portfolio fall that much is just the kind of situation that can stir an investor’s emotions—and sometimes lead to short-term decision making, including flight from equities. But let’s look at what happened when the market started to come back. By April 2013, our hypothetical all-stock portfolio would have risen by 127.5%, the diversified portfolio by 94.2%, and the all-cash portfolio by 0%. The all-stock portfolio got the biggest lift during the market’s upswing. This is a good example of how such portfolios can behave in rising markets. If the market is in an upward trend, the diversified portfolio may gain less than the all-stock portfolio and more than the all-cash portfolio.
Now let’s look at what happened over a longer cycle. From January 2008 through April 2013, the diversified portfolio was up 17.8%, while the all-stock portfolio was up 13.9%. This is what diversification is about. It will not maximize gains in rising markets, but it can help limit losses when the market is turning down.
The high price of bad timing
As the example above illustrates, the value of a diversified portfolio can play out over time. Unfortunately, many investors struggle to realize the benefits of their investment strategy because in buoyant markets, people tend to chase performance and purchase higher-risk investments. In a market downturn, investors tend to flock to lower-risk investment options, which can lead to missed opportunities during ensuing market recoveries. The degree of underperformance by individual investors has often been the worst during bear markets. Studies have consistently shown that the returns achieved by the average stock or bond fund investor have lagged, often by a large margin, the reported returns of the average stock or bond mutual fund.
The data below from DALBAR show that fund investors trail the market significantly. This means the decisions investors make about diversification and when to get into or out of the market, as well as about fees or underperforming funds, cause them to generate far lower returns than the overall market (see the chart below).
“Being disciplined as an investor isn’t always easy, but over time it has demonstrated the ability to generate wealth, while market timing has proven to be a costly exercise for many investors,” observes John Sweeney, executive vice president at Fidelity Investments. “We encourage investors to have a plan that includes an appropriate asset mix, and then rebalance on ongoing basis.”
How to build a diversified portfolio
To start, you need to make sure your investment mix (e.g., stocks, bonds, and short-term investments) is aligned to your investment time frame, financial needs, and comfort with volatility. The sample target asset mixes below show some asset allocation strategies that blend stock, bond, and short-term investments to achieve different levels of risk and return potential.
How rebalancing may be able to help
Diversifying alone is not enough. Once you have a target mix, keep it on track with periodic checkups and rebalancing. If you don’t rebalance, a good run in stocks could leave your portfolio with a risk level that is inconsistent with your goal and strategy.
What if you don’t rebalance? Let’s look at a hypothetical portfolio over a historical 20-year period to illustrate how changing markets, such as last year’s large rise in the S&P 500, can have an impact on an investment mix—and, in turn, on the amount of risk in a portfolio.
Consider a hypothetical growth portfolio with 70% in stocks (49% U.S. and 21% foreign), 25% bonds, and 5% short-term investments in April 1993. Two decades later at the end of April 2013, the bull market of the late 1990s and the run up after the financial crisis would have changed the investment mix dramatically—to nearly 80% in stocks (62% U.S. and 18% foreign), 18% in bonds, and 2% short term (see the chart above).
That extra stock meant more risk. Why? Because while past performance does not guarantee future results, stocks have historically had larger price swings than bonds or cash. This means that when a portfolio skews toward stocks, you have the potential for bigger ups and downs.1 In fact, the portfolio’s risk level as of April 2013 was nearly 10% greater than that of the target mix due to changes in the asset allocation associated with the relative returns to stocks, bonds, and cash (see the chart below). (Portfolio risk is measured by the annualized standard deviation of monthly returns, which shows the variability of a portfolio’s returns.)2
Let’s take a closer look at the risk levels of the hypothetical portfolio over time. The chart below shows the hypothetical portfolio’s risk for two scenarios: if the investment mix were rebalanced back to the target every year and if no changes were made—buy and hold. As you can see, the risk of the buy-and-hold portfolio varies more widely than that of the rebalanced portfolio. On average, during this time period, the buy-and-hold portfolio experienced higher risk (annualized portfolio volatility).
Rebalancing is not always a risk-reducing exercise. The goal is to reset your investment mix to bring it back to the expected and appropriate risk level for you. Sometimes that means reducing risk by increasing the portion of a portfolio in more conservative options, but sometimes it means adding more risk to get back to your target mix. That could mean increasing investments in riskier asset classes such as stocks. Investing is an ongoing process. You need to create a plan, choose appropriate investments, and then conduct regular checkups to keep your portfolio on track. Here are the three steps to do just that:
1. Know your target investment mix
If you haven’t already done so, choose a mix of stocks, bonds, and short-term investments that you consider appropriate for your investing goals. Take into account your financial situation, tolerance for volatility, and when you will need the money you are investing.
For example, if you’re investing for goals that are more than 10 years away, or you have a higher tolerance for risk, you may want to allocate a larger portion of your portfolio to stocks, which historically have offered the highest potential for growth over time.
On the other hand, if you’ll need the money in just a few years—or if the thought of potentially losing money makes you too nervous—consider a higher allocation to generally less volatile investments such as bonds and short-term investments. By doing this, of course, you’d be trading the potential of higher returns for the potential of lower volatility.
2. Review your portfolio regularly
We suggest you—on your own or in partnership with an investment professional—monitor your investment mix and rebalance it at least annually, or whenever your financial circumstances change. As a guideline, you may want to consider rebalancing if your stock allocation moves away from your target by more than 10 percentage points.
There are a couple of ways to rebalance your portfolio. One is to sell those assets you currently have too much of and reinvest the proceeds in those that fall short of your target. But selling securities in taxable accounts generally has tax consequences in the year of a sale, so be sure to consider taxes when making any decisions to sell. A way to rebalance without immediate tax consequences is to invest any new money you have (savings contributions, bonus, etc.), either gradually or all at once, in investments in asset classes that currently fall below your target. Regardless of which approach you take, one important aspect of rebalancing is that you do it in a way that also keeps your portfolio diversified within each type of investment.
“Achieving your long-term goals requires balancing risk and reward,” says Sweeney. “Choosing the right mix of investments and then periodically rebalancing and monitoring your choices can make a big difference in your outcome.”
- For help analyzing your overall portfolio, choosing a target asset mix, and rebalancing your portfolio to bring it in line with that target mix, try Portfolio Review.
- Research professional management of your portfolio with Fidelity Portfolio Advisory Service.®4
- Consider a single-fund strategy such as Fidelity Freedom® Funds5 or Fidelity Asset Manager® Funds.
- Consider a variable annuity that provides you with guaranteed lifetime income.6
- Call a Fidelity Investment Professional at 800-343-3548 to discuss your goals and objectives and help determine the right investment mix for you.
Before investing, consider the investment objectives, risks, charges and expenses of the fund or annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a free prospectus and, if available, summary prospectus containing this information. Read it carefully.