That’s why portfolio experts stress the importance of diversification, asset allocation, and periodic rebalancing, rather than touting the latest “can’t miss” stock buy. However, due to the fact that hot stock tips often seem more interesting than diversification strategy, many investors continue to play the market-timing game rather than maintain a solid long-term strategy.
In a recent presentation on bond performance, Craig L.
Israelsen, an associate professor of finance at Brigham Young University,
provided a clear and convincing example of the power of asset allocation to
improve returns over time. He compares the performance of portfolios with one
asset, two assets, and four assets from 1948 through 2012 to show that portfolio
diversification trumps securities or fund selection. The accompanying chart, “Bond Performance in a Portfolio Context,” analyzes returns from three different portfolio mixes under conditions of rising interest rates and declining interest rates. The analysis shows that market performance doesn’t affect returns nearly as much as diversification of a portfolio.
The 34-year period from the start of 1948 through 1981 was a time of rising interest rates, and U.S. bonds averaged an annualized return of 3.83%. During that period, the Standard & Poor’s 500 stock index averaged 11% annual gains while U.S. Treasury bills averaged 4.49%.
The 31-year period from 1982 through 2012 was a time of declining interest rates, during which U.S. bonds averaged an 8.82% gain annually, the S&P 500 averaged 11.14%, and U.S. Treasury bills averaged 4.72%.
So the background to this portfolio comparison is the fact that U.S. bonds clearly performed much better during the latter period. Because analysts expect interest rates to rise during the next few years, it may be reasonable to conclude that bond returns likely will fall. “The question is how much does (this) matter in terms of building an overall portfolio,” Israelsen asked in his presentation.
To find out, he analyzed the performance of a simple two-asset portfolio during those same two time periods, cutting bonds to 40% of the portfolio and adding large U.S. stocks as 60%. Not surprisingly, adding returns from the more volatile equities market increased the portfolio’s annualized return to 8.52% during the 1948-1981 timeframe and to 10.56% during the later period.
Then Israelsen moved into a more diversified portfolio with four asset classes: 40% large U.S. stocks, 20% small U.S. stocks, 30% bonds, and 10% cash. That resulted in a 9.52% annualized return in the earlier period and a 9.99% return in the later period.
The increasing rates of return for the earlier period—and the decreasing differences between returns for the two time periods—clearly shows the benefits of diversification. Bonds alone produced positive returns, but when combined with equities, the returns rose – regardless of which way interest rates were moving.
Some investors may look at these figures and wonder why they shouldn’t simply eliminate bonds and put all their assets into equities. The answer involves risk and an investor’s time horizon. In general, U.S. equities tend to have two to three years of negative returns during every 10-year period. That increases the risk your portfolio might take a hit just before you intend to retire or before you need to make a withdrawal for other reasons.
Bonds experience an average of two very slight negative-return years per decade, so they provide a stabilizing influence that can smooth out your portfolio’s performance. That’s the whole point of diversification, to avoid putting all of your investment dollars at risk at the same time.
A final point: Periodic rebalancing is vital, because as asset classes rise and fall in value, your portfolio mix will change. If you start with 30% in large U.S. stocks and this class performs well, that portion of your portfolio may grow to 35% or 40% of the whole, throwing off the balance in the portfolio. So you have to rebalance, either by selling some of the large-stock holdings or buying more in your other asset classes.
Our firm can help you with each aspect of meaningful portfolio design—asset allocation, risk management, and rebalancing – within the context of your overall financial situation and life goals.
