- 6-Minute Article
- Feb 09, 2018
How to Make the Most of Diversification
A look at the crucial role diversification plays in retirement planning — and how to enhance its benefits.
People saving for retirement are in control of two powerful factors that can help them meet their goals: the amount of money they save and the mix of stocks, bonds, and other assets they purchase with that money to help their savings grow. Holding a variety of stocks, bonds, and alternative assets with different growth characteristics and risk factors — an approach known as diversification1— can help lessen the effect of ups and downs caused by changes in market conditions over time. In fact, some estimates say that a diversified mix of assets in a portfolio is responsible for 90% of its long-term returns.2
Everyone’s retirement goals and risk tolerance varies, but diversifying among asset classes can help create customized strategies to achieve individual needs. A financial advisor can also play a key role in understanding how to properly diversify retirement savings. To help make the most of the opportunities that diversification provides, here is a look at important considerations when choosing a mix of assets for a retirement plan.
Balancing Growth Potential and Protection in a Long-term Plan
Exposure to a certain degree of risk can improve long-term growth potential, because riskier investment options typically offer the chance for higher returns. Historical market data shows the evidence for this relationship between risk and potential rewards: Since 1926, stocks have generated much higher compound annual returns than bonds — 10.0% vs. 5.5% — because stocks are a more volatile investment. Their value can rise or fall sharply during short periods in response to economic conditions or market factors.
The stocks of smaller companies have outpaced large company stocks, delivering a 12.1% compound annual return since 1926 compared to the 10.0% return for large company stocks.3 This is because smaller company stocks are perceived to be more risky than large company stocks, due to smaller companies tending to have fewer financial resources, smaller product lines, and/or relatively untested management teams.
But riskier assets also carry the chance for greater losses — and short-term market downturns are inevitable in the pursuit of longer-term gains. That’s why it’s important to consider the potential impact of downturns on a long-term investing strategy. As the chart below shows, the gains required for a portfolio to fully recover from a downturn increase with the magnitude of the loss. For example, a 20% loss requires a 25% gain just to break even, while a 30% loss requires a 43% gain to break even, a 50% loss requires a 100% gain to break even, and so on. In short, it takes an increasingly higher gain to offset a larger loss, making it important to try and avoid these losses in the first place.
An even larger gain is required to restore account values after a downturn when people are also making withdrawals from their investment portfolios. For example, someone withdrawing 5% annually from their retirement savings account over five years would need a cumulative gain of 82% before their savings recovered their value after a 20% decline.4
Because of the risk of steep downturns, a retirement portfolio should be diversified to reduce the impact of a single asset class performance. Blending several asset classes that provide a spectrum of risk and return characteristics can help reduce a portfolio’s ups and downs. If one type of asset experiences a temporary decline, other assets in a portfolio might offer gains that help stabilize overall returns.
For example, diversifying a portfolio between stocks and bonds tends to reduce risk, because bonds are less volatile than stocks and may continue to perform well when the stock market takes a hit. Consider the chart below, which shows how positive bond returns would have helped partially cushion savings from steep declines brought on by three major financial crises.
When stocks and bonds are combined in a diversified portfolio, not only do downturns tend to be less dramatic, recovery times tend to accelerate. Consider this example from the 2008 financial crisis: $100,000 invested in the S&P 500 would have lost half its value between October 2007 and March 2009 — the market’s low point during the recession. It would be four years before that investment recovered from that loss, and many investors sold their stocks in the face of such a dramatic setback, losing the opportunity to participate in the recovery.
Compare that to $100,000 invested in a mix of 60% stocks and 40% bonds, which would have declined to only around $70,000 between October 2007 and March 2009. This more diversified portfolio also would have recovered more than a year earlier, in February 2012, putting investors through less stress and reducing the temptation to abandon their stock investments.
Smaller declines and quicker recoveries allow retirement savings to start growing again sooner after market downturns. In this way, diversified portfolios help people pursue their retirement plans with less potential ups and downs in the value of their savings.
Broadening Diversification for Greater Protection
There are ways to enhance the benefits of diversification. One approach is to build a retirement plan that includes a broader range of investment products beyond IRAs, 401(k)s, and other traditional investment accounts — this is known as product diversification. Another strategy is to strengthen investment diversification by broadening a savings mix to include more asset classes. While many people are familiar with the large company stocks represented by the S&P 500 and investment-grade corporate bonds, the investment universe is much bigger than these two asset classes. The wide range of available asset classes provides opportunities for greater diversification, because different asset classes react differently to prevailing economic and market factors — sometimes dramatically. As a result, returns from each asset class vary widely from year to year, as is shown in the table below that ranks the annual returns of nine major asset classes, along with the returns of a portfolio invested in 60% stocks/40% bonds, over the past 16 years.
Strong-performing asset classes one year could be among the lowest-performing classes the next year and vice versa. For example, stocks from emerging markets (labeled Emerging Market Equities) lagged most other types of investments from 2013 through 2015. But they began to recover in 2016, and delivered the best performance in 2017. By contrast, U.S. bonds delivered the worst returns in 2017 and had poor performance in 2016. But U.S. bonds often provided the best overall returns during years when the stock market suffered — such as in 2008.
Because no single asset class outperforms the others consistently, diversifying broadly among several asset classes can help even out the ups and downs in a retirement savings over time. Diversified portfolios can capture the gains available in different areas of the market and help protect savings from excessive losses due to poor performance from certain asset classes.
To help provide more content on the topic of diversifying more broadly, someone saving for retirement might diversify their stock investments among large-cap, mid-cap, and small-cap stocks that may perform differently in the same year. Meanwhile, adding exposure to international investments can help savings weather downturns in the U.S. markets, and high-yield bonds can provide an alternative to investment-grade corporate bonds. A financial advisor can help develop a diversification strategy that balances these asset classes to provide the right mix of potential returns and risk potential.
Embracing opportunities for deeper and broader diversification can help people saving for retirement develop a strategy that keeps them on track for their long-term goals. Work with your financial advisor to create the diversified mix of assets that works for your needs.