- 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
Everyone’s retirement goals and risk tolerance
Balancing Growth Potential and Protection in a Long-term Plan
Exposure to a certain degree of risk can improve long-term growth
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
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.
Gain Required To Fully Recover From A Loss
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.
How Bonds Can Help Buffer Stock Market Losses
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.
Impact Of Losses And Recovery Time
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
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
Asset Class Annual Returns: 2001-2017
Because no single asset class outperforms the others consistently, diversifying broadly among several asset classes can help even out the ups and downs in
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.