Weekly Market Update
In this edition of Weekly Market Update, we continue our discussion of diversification and its application to investor portfolios. We explain how there is no single “universal” diversified portfolio suited to all investors and occasions. Instead, diversification is a highly customizable framework that can and should be uniquely tailored to suit each individual investor’s goals and risk tolerances.
Earlier articles in the series discussed the basic benefits and rationale for diversification; the ways in which diversification can help minimize classic investor behavioral errors; and a discussion of alternative investments that can be used to diversify a traditional balanced portfolio of stocks and bonds. Future articles will address some of the common criticisms of diversification in the wake of the 2008 Financial Crisis.
Individual Goals, Individual Portfolios
The financial historian Peter Bernstein once famously wrote in a discussion of uncertainty, risk taking, and the consequences of our financial decisions that “consequences are more important than probabilities.” He makes several key points in this discussion. The first is that you cannot predict future financial outcomes with any degree of certainty. The second is that because you cannot be right all the time, you do well to think about the consequences of your decisions—what is the cost of being wrong? Third, he cautioned against seeking to maximize returns and focusing instead on managing risks, precisely because the consequences of wrong financial decisions—going broke—are so great.
Much of Bernstein’s work on the subject reads as an homage to the theory of diversification—using carefully thought out strategies to manage risk and reduce the likelihood of the permanent loss of capital. Indeed, he was often heard to say that individual investors should focus on asset allocation and diversification as tools to manage risk and improve financial outcomes.
Bernstein was also clear that tolerance for loss varies among individuals, and that even the same individual will have different risk tolerances at different stages of life. As a result, we can say that no two investors’ diversified portfolios are likely to be the exact same, nor should they be. Moreover, the portfolio of the same investor should be different at age 40 from that at age 60 and age 80. So while the principles of diversification are universal, they can easily be individually tailored in accordance with each investor’s goals, risk tolerances, and exposures.
Diversification and portfolio customization go hand in hand. Each individual’s return objectives and risk tolerances can and should be met with a tailored investment solution. While we can’t discuss all the possible portfolio combinations, what we can do is provide a list of considerations or factors you should consider when constructing your own portfolio, or when speaking with a financial professional about your financial situation.
At a high level, the key considerations for every investor will be:
- tolerance for loss (remember, consequences are more important than probabilities);
- current income and liquidity requirements;
- tax situation;
- investment horizon;
- whether you are contributing to your portfolio (accumulation phase) or actively withdrawing from your account (distribution phase); and
- your wealth and savings levels in relation to your anticipated needs.
These considerations will help you strike the right balance between income generation, growth orientation, risk tolerance, inflation protection, etc.
How Much and What Kind of Diversifiers Should I Hold?
The exact number and type of diversifiers are not universal constants. Rather than focus simply on the number and types of asset classes in your portfolio, the key is to carefully analyze the relative volatilities (risk) and correlations (interaction) of those assets in order to determine optimal allocations. Said differently, from the point of view of diversification, it is better to hold fewer uncorrelated assets than many highly correlated positions, all else equal.
Example of a Diversified Portfolio
While there is no “one allocation to rule them all,” it may be useful to have an example of a well-diversified portfolio to help frame your thinking. For example, the typical 60/40 “balanced” or “moderate” stocks/bonds portfolio actually is composed of many different slices, each with their own risk, return, and correlation characteristics (see Figure 1).
Within the equity allocation, one might well expect to hold investments representing both large- and small-company stocks, as well as growth- and value-oriented shares. In addition, it’s desirable to have exposure to international equities from both emerging and developed market economies.
In the high-quality, investment-grade portion, the bond allocation will likely include government and corporate securities, as well as mortgage- and other asset-backed bonds, and cash-equivalent securities. High-yield corporate securities are another fairly widely held asset class.
In this example, we have six types of equity investments (large- and small-cap domestic growth and value shares, as well as international developed and emerging market equities) and five types of fixed-income investments (government bonds, investment-grade and high-yield corporate securities, mortgage-backed bonds, and cash). Note that these investments each have unique risk profiles and correlations that give them a tremendous diversification benefit when combined into a single portfolio.
Allocating to Alternative Investments
That 60/40 allocation alone will provide investors many diversification benefits. But many financial professionals and sophisticated investors are also incorporating so-called “alternative investments,” which we discussed in our Introduction to Alternative Investments.
As practiced today by most financial advisors, the typical balanced or moderate portfolio probably looks more like 50/30/20 stocks/bonds/alternative investments than the traditional 60/40 allocation. Indeed, American Century Investments’ own recent survey of financial professionals about their use of alternative investments found that 17% of their clients’ portfolios were allocated to alternatives.
These “alternative” holdings would include things like real estate investment trusts, commodity-based investments, inflation-protected securities, international bonds, and absolute return or real return vehicles, among others. The ultimate decision about whether to allocate to alternatives or not is a function of several variables, including your objectives, risk tolerances, time horizon (time to retirement, for example), and, crucially, vulnerability under various economic and market scenarios.
Scale Alternatives to Match Risks
We should say something specifically about retirement investing. It turns out that in many ways, the retirement date is the point at which investors face the greatest risk—your account is likely at its greatest dollar value; you must finance the greatest amount of time in retirement; and you will no longer be making regular contributions to offset declines in performance or purchasing power. As a result, the closer to retirement, the greater the risk from volatility and inflation.
For this reason, our analysis suggests that investor portfolios should reach their most conservative allocation at the retirement date—your equity exposure would be at the lowest level possible consistent with minimizing market risk but still providing enough growth potential to fund a long retirement. Meanwhile, your exposure to volatility and inflation hedges would likely be at their highest level at retirement compared with any other point in your investing lifetime.
For example, an investor nearing retirement worried about preserving purchasing power would be more likely to hold a greater allocation to inflation-protected investments than would an investor long before or after the retirement date (because account balances are likely to be so much greater in the crucial years around retirement).
Incorporating Alternatives: Proportional Representation
Finally, we are frequently asked by investors what source of funds to use when looking to add a diversifier, an alternative investment, to their portfolio. In other words, if you have a 60/40 portfolio and want to add an allocation to real estate investment trusts, or inflation-protected bonds, for example, how do you go about it?
We suggest that investors looking to add alternatives should seek to make any changes proportional to the asset allocation of the overall portfolio. For example, a 10% allocation to inflation-fighting strategies in a traditional 60/40 stock/bond portfolio might mean a 6% overall allocation to stocks of commodity producers or to real estate investment trusts, along with a 4% overall allocation to inflation-linked bonds. In that case, the allocation would now look like this: 54+6/36+4. The reason for doing it this way is to maintain consistent risk tolerances and relationships in your original investment plan.
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Diversification does not assure a profit nor does it protect against loss of principal.
This information is not intended to serve as investment advice; it is for educational purposes only.
The opinions expressed are those of Rich Weiss and are no guarantee of the future performance of any American CenturyInvestments portfolio.