The first step in any investment strategy is to clearly identify your long-term goals. Whether it’s a comfortable retirement, second home, or leaving a legacy for your children or grandchildren, having a plan for your long- and short-term financial goals makes it easier to ride out the inevitable ups and downs of the financial markets.
The goal of asset allocation is simple: to optimize return potential for a stated level of risk. Or to put it more precisely, to identify the most efficient mix of assets that will provide the highest potential for return, given the level of risk you are willing to assume.
Strategically combining asset classes increases the possibility of reaping the potential long-term returns of each asset class, while, to a degree, smoothing out the inevitable ups and downs of the various equity and bond markets.
History has proven that selecting the right asset allocation is more than an art; it’s also a science. This is best demonstrated by the illustration below — a chart plotting the historical risk and return for various portfolios, each with assets allocated between large-cap stocks and bonds. As seen in the chart below, when making allocation decisions you can balance performance goals and the amount of risk you’re willing to assume.
Investors seeking a greater average annual total return by allocating a portion of their portfolio to stocks have, historically, had to assume a higher degree of risk. Based on these statistics, the return potential you seek is directly related to the amount of volatility you are willing to bear.
By diversifying your portfolio, you may be able to better manage the balance between risk and return potential. This may help you feel more comfortable staying with your investment strategy over time.
Source: FactSet. Risks and returns for portfolios comprising the Standard & Poor’s 500 Index and the Barclays U.S. Aggregate Index. Portfolios rebalanced monthly. Actual investment returns will vary and may be greater or less than the index. Past performance is no guarantee of future results.
The S&P 500 Index is a widely accepted, unmanaged index of U.S. stock market performance. An investor cannot invest directly in any index. The Barclays U.S. Aggregate Index is a widely accepted, unmanaged total return index of corporate, government and government-agency debt instruments, mortgage-backed securities and asset-backed securities with an average maturity of 1-10 years. Investors cannot invest directly in any index.
Standard deviation is the statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. It is widely applied in modern portfolio theory, where the past performance of securities is used to determine the range of possible future performance, and a probability is attached to each performance.
THE CHANGING FACE OF MARKET LEADERSHIP
Diversification among asset classes is one of the cardinal rules of investing for a good reason. Remember — the asset class that is hot today may not be tomorrow.
For example: During the equity bull market of the 1990s, many investors may have lost sight of the appeal of holding bonds in a portfolio. The stock market reversal of 2000, 2001 and 2002, however, hit some portfolios hard and brought the desirability for an allocation to bonds back into the spotlight. The year 2008 was one of the most difficult years in history with investors once again focusing on U.S. Treasury instruments, further illustrating the importance of diversification.
By spreading assets among stocks, bonds and cash you are less likely to be overexposed to any single asset class. Since economic, financial and political changes generally affect asset categories differently, a properly diversified portfolio is potentially better positioned to weather market fluctuations.
It may also be possible to reduce the overall risk of your portfolio with asset allocation. In some periods, one asset class may be rising while another is declining, thereby smoothing out your overall portfolio. Of course, diversification alone does not guarantee a profit or protect against loss.
Past performance is no guarantee of future results. Results for actual investments will vary. The comparison is intended to illustrate the changing market leadership in terms of stock market performance over time and the potential benefits of a diversified investment approach. It is not intended to promote the performance of any index or actual investment, which may be less than these returns show. It is not possible to invest directly in any index.
Staying the Course
Asset allocation is a strategy for long-term investors, not for those seeking quick profits from short-term movements in individual stocks or the market as a whole.
Historically, the length of time you’re in the market has made the largest contribution to returns. Anytime you sell assets while the market is declining, you risk missing the upward trends that have historically followed these periods.
It is impossible to accurately predict market performance. By trying to avoid the “worst” days to invest, investors may miss the “best” days, which could significantly reduce a portfolio’s return.
This hypothetical chart highlights the price paid by an investor for missing the “best days” for stocks over the past 25 years. If the investment were left untouched it would have achieved an average annual total return of 9.61%.
However, if the investor had attempted to time the market, and inadvertently missed the market’s best days, the return would have been substantially lower. This illustrates the risk of market timing compared with staying invested.