Dear Readers: Here we go again. In early March, the COVID-19 pandemic brought the 11-year bull market to a crashing halt. Since that time, the markets have largely recovered but been plagued with extreme volatility, leaving individual investors frightened and confused. While every investor knows that risk comes with the territory, the recent wild gyrations are enough to make even the hardiest investors feel unsure.
Still the Best Investment Strategy
Asset allocation and diversification seem pretty similar, and a lot of folks confuse the two, but they’re actually quite different. A key to creating a sound investment portfolio is to understand that difference and how the two work together.Asset allocation is the way you divide your money among major investment categories like stocks, bonds, cash, and other types of investments, some of which are riskier than others. Therefore, this division into the various asset classes should be based on how much risk you’re comfortable taking and how soon you’ll need your money.
While stocks have the highest return potential, they also carry the highest short-term risk. Cash, on the other hand, has the lowest return potential but the least amount of short-term risk. Bonds are somewhere in between. Any money you’ll need within the next three to five years should be kept in lower-risk investments.
Asset allocation was first introduced as a way to manage risk in the 1950s. Research showed that a portfolio’s overall risk and expected return were a result of how each underlying investment performed individually, as well as how investments behaved together. By choosing a variety of investments that react differently to market conditions—or those that have a low correlation to each other—an investor could reduce overall risk.
And within those divisions, you can diversify further by investing in different sectors (i.e. technology, health care, telecommunications) and different industries within the sectors. In the case of bonds, you can diversify within government, government agency, corporate, international, and high-yield (“junk”) bonds of different maturities.
Your ultimate goal is to find investments that don’t move in lockstep with one another. That way, when one investment goes through a rough patch, another will hopefully compensate.
Adapting to Changing Market Realities
So what, if anything, has changed? As first became apparent during the Great Recession of 2008, globalization has made markets more susceptible to external shocks, causing increased volatility and stronger correlations between asset classes. This surprised investors who had expected different asset classes they held to zig while others zagged and instead experienced that as asset classes zigged, the others zigged, too—or zagged by a much smaller amount.This doesn’t mean, however, that diversification and asset allocation didn’t work; they just didn’t provide the level of protection that one would have hoped for. If anything, this experience shows us that we need asset allocation and diversification more than ever. Market volatility only reinforces their importance.
The relatively new availability of low-cost “nontraditional” asset classes can help. Investments like real estate (real estate investment trusts, or REITs), commodities (energy, agriculture, precious metals), Treasury Inflation-Protected Securities (TIPS) and international bonds have historically had low correlation to traditional asset classes—moving differently in different markets—so adding small amounts to your portfolio can increase your diversification, potentially lowering your investment risk over time. The exact amount you use depends on your situation and investment preferences.
How to Stay on Top of It All
But you can’t stop there. Once you’ve built your well-diversified portfolio, it’s also essential to stay involved.In general, it’s smart to review your portfolio and rebalance at least yearly to stay within your target mix of investments based on your risk tolerance and time horizon. But in times of extreme volatility, you might want to do this more frequently, perhaps quarterly. Alternatively, you can rebalance when your investments fall outside of 5 percent of your target allocation.