The stock market experienced a quick and powerful correction during the 4th quarter of 2018, led by global growth concerns, trade wars, and a hawkish Fed. However, these concerns have since abated, and the stock market was able to recover and produce new all-time highs. Nevertheless, the latest correction served as a reminder for when volatility develops, stock prices can lose value rather quickly, but having the proper asset allocation and diversification can help weather the damage of a significant stock market correction.
Asset allocation is the strategy of distributing investments between different asset classes such as stocks, bonds, and cash to reduce risk and maximize risk-adjusted return. By having your portfolio invested in a mixture of asset categories that each have unique risk characteristics and correlation, you can create an investment portfolio that produces the best return for the lowest amount of risk. Furthermore, you can protect your portfolio from losing substantial value when one asset class declines precipitously; large losses in one asset class can be offset with gains by other investments.
With the stock market back near all-time highs, investors sometimes forget about the importance of their bond allocation inside their portfolio. When making asset allocation decisions, an investor should always ask themselves: “Can I afford not to be invested in bonds?” When the stock market lost substantial value during the financial crisis, U.S. Treasury prices rallied as investors moved their money into a less risky asset class. A portfolio that included stocks and bonds performed better than one invested in only stocks during the market crash. However, when the stock markets have substantial gains as it has as of late, a balanced portfolio will underperform the stock market. The bottom line though is that investors should never forget the importance of their fixed income allocation because over a full market cycle, a balanced portfolio will produce superior risk-adjusted returns.
Having the proper asset allocation is therefore essential to achieving one’s investment goals. The allocation ratio should reflect an individual’s risk tolerance and time horizon. A rule of thumb is to invest your age in bonds. An investor nearing retirement that is 60 years of age should be roughly 60% in bonds and other less volatile investments, with the balance in stocks. Conversely, a young investor that is 30 years of age and saving for retirement has a long time horizon, and thus, should have a more aggressive allocation towards stocks of roughly 70%, and 30% in fixed income. These ratios can have some flexibility of plus or minus 10% depending on market conditions, valuations, the ability to take risk, and the stage of the business cycle.
Once an appropriate mix of stocks, bonds, and other investment vehicles has been determined, the equity portion of the portfolio should be diversified to reduce stock market risk. You can reduce market risk by using a combination of funds with investment objectives in multiple market capitalization, growth, value, and international stocks. An investment portfolio should not contain only large-cap companies and domestic stocks. Having a portfolio that includes small and mid-cap companies, in addition to international, both developed and emerging market countries will help produce a well-diversified portfolio that reduces risk.
Additionally, diversifying with a mix of growth and value-oriented companies will further reduce overall portfolio risk. Growth stocks consist of companies that tend to have earnings that grow faster than the general markets and are unlikely to pay a dividend. Growth stocks tend to outpace the overall market when the economy is healthy and expanding.
Alternatively, value stocks consist of companies that are considered to be undervalued but have strong fundamentals and often pay dividends to their shareholders. Value stocks tend to underperform when the economy is growing. However, they tend to limit downside risk in a portfolio when the economy is contracting and offsets losses from more aggressive segments of a portfolio. Having the right balance of both growth and value stocks will prove beneficial through a full market cycle.
Asset allocation and diversification is critical for minimizing risk in one’s portfolio. Using an asset allocation strategy containing both stocks and bonds, along with a variety of funds with different investment objectives, will help produce a portfolio that is diversified and has limited risk in the event one aspect of the portfolio loses significant value. Although the stock market has produced substantial returns as of late, we are in an aging economic cycle where volatility is likely to become more prevalent. Therefore, right now is the perfect time to consult with your investment professional to make sure you have the proper asset allocation that will meet your long-term goals.