Setting your asset allocation is like drafting architectural plans when building a home; it provides a map to guide the construction of your investment portfolio. Developing an asset allocation is a multi-step process, which is challenging for many investors, and for good reason. A Google search for the term “how to set your asset allocation” yields 56 million results! How can you tell which sources are credible or which advice is appropriate for your individual situation? Achieving asset class diversification seems more difficult than ever. These four charts illustrate the importance of diversifying between asset classes and within asset classes.
To complicate matters, the universe of mutual funds, ETFs, stocks, and bonds available for investment is vast and includes thousands of options. Fund selection is an often-overlooked step in the asset allocation process. Choosing the wrong funds is akin to picking poor finishes when building your home. A massive open-concept kitchen with a large island doesn’t look so grand with laminate countertops and wall-to-wall carpet.
3 Main Steps in Developing Your Asset Allocation
- Understand your risk tolerance. Based on various factors, such as your financial goals, time horizon, and opinion on an acceptable risk/reward framework, you should come up with a general sense of your risk profile.
- Select your asset classes. Using your risk profile, you will need to decide what percentage of your portfolio to allocate towards the main asset classes. This includes equity (stocks), fixed income (bonds), cash, and real estate. Generally, the more conservative you are, the higher the allocation to fixed income and cash, up to a point. The importance of maintaining a diversified mix of asset classes is the central focus of this article and will be discussed in detail. Once you have your basic allocations, the next step is to define your allocation within these asset classes. For example, the equity asset class can be divided up in a number of ways: large cap, mid or small cap, international developed or emerging markets, Europe, and so on.
- The final step is to identify the best investment funds in each asset class to achieve your desired asset allocation. Here are a few of the top considerations, though there are many: fund longevity, relative performance, management style (e.g. active or passive), investment style (e.g. value vs growth stocks), expense ratio, and trading volume.
This article will only focus on step 2 above and explore why asset class diversification is crucial to mitigate unnecessary risk and reduce volatility in a portfolio.
Asset class diversification: two sides to every coin
What’s Good for the Goose is Good for the Gander?
The old adage meaning what is good for one benefits all does not apply to the financial markets. Take low unemployment for example. Most of us think low unemployment is a positive thing, and generally it is. But for companies, it usually means high-demand workers have more leverage to command higher wages. This hurts profitability for shareholders and positions become harder to fill which impacts sales, ultimately reducing net earnings for shareholders.
There are a number of factors that influence how an asset class will respond to changes in the market or future expectations. These factors include interest rate fluctuations, a company’s quarterly earnings report, news of a merger or acquisition, large capital expenditures, geopolitical risks, environmental and legislative conditions, shifting consumer sentiment, commodity prices, and so forth.
Economic conditions impact asset classes differently
Consider the potential impact of rising interest rates on equity (stocks) and fixed income (bonds). Rising interest rates will increase the cost of borrowing for businesses. Further, equity investors may grow concerned about reduced profitability due to higher debt payments or a delay in capital expenditures intended to produce growth. When net earnings suffer, equity investors may receive a reduced dividend payment or the stock price could drop.
For bondholders, rising interest rates can mean higher yields. When interest rates rise, the prices of existing bonds drop. This is because demand for existing bonds goes down when newer bonds with better yields become more attractive.
Financial markets are intertwined, so this isn’t always the end of the story. Rising interest rates and bond yields often come full circle back to the stock market. If a “risk free” money market fund is now paying 2% interest, up from 1%, equity investors will require a higher return to compensate for the additional risk. This sometimes causes stock prices to fall.
Range of Returns Between Asset Classes
The Callan Periodic Table of investment Returns ranks major asset classes annually by returns and it’s one of the best tools to illustrate the power of asset class diversification.
Returns for 9 indices representing major asset classes are plotted from 2000 – 2019 in the table below. The movements of large cap stocks (represented by the S&P 500) are tracked on the yellow line, ex-US equity (MSCI World ex USA) are represented by the black line, and US bonds (Bloomberg Barclays US Aggregate Bond Index) is reflected on the blue line.
Historical Chart: Performance of Bonds vs Stocks (US vs International)
In most years, the equity indices (yellow and black lines) move in similar directions, at different magnitudes, and typically end up closer together than the US bond index (blue line). The two notable exceptions on this chart are 2014 and 2015, when non-US equity underperformed relative to US equity and bonds.
For many investors familiar with the principles of diversification, these movements and trends are to be expected.
Range of Returns Within an Asset Class
The benefits of allocating funds between different asset classes is pretty well understood. But the reasons to diversify within a particular asset class isn’t as well-known. But the same principles apply.
The Russell 3000 is the most broad-based and diversified index on the chart, representing the largest 3,000 public companies, including large cap, mid cap, and small cap stocks, equaling roughly 98% of the market capitalization of the US stock market.
According to data from Morningstar, the annualized return of the Russell 3000 TR USD was 6.38% between 2000 – 2019.
Chart: Historical US Stock Market Returns (Russell 3000, Ranked)
The ranked returns for the Russell 3000 (a proxy for the whole US stock market) falls within the black box below.
Russell 3000 vs S&P 500
Using the same table, the ranked returns for the S&P 500 are now highlighted. The S&P 500 is frequently used to represent the entire US equity market, as it encompasses roughly 80% of the market capitalization of all public US stocks by tracking the largest 505 companies.
The S&P 500 beat the Russell 3000 by performance in 9 of the last 20 years. Despite the coin-flip odds, notice how much more volatile the large cap index is compared to the broad-based Russell 3000. According to data from Morningstar, the annualized return of the S&P 500 TR USD was 6.05% between 2000 – 2019, slightly lower than the Russell 3000.
Chart: Russell 3000 vs S&P 500 Historical Returns (Ranked, 2000 – 2019)
Mid-Cap vs Large Cap vs The Whole US Stock Market
In the final table, the ranked returns for the S&P 400, which tracks mid cap US stocks, is now added to the picture. Like most asset classes that exclude large cap equity, the S&P 400 represents a relatively small portion of the entire US stock market. Mid-cap companies are a component of the Russell 3000, though performance specific to this asset class will be somewhat muted when holding a broad-based fund.
Like the S&P 500, the S&P 400 is also more volatile than the Russell 3000. According to data from Morningstar, the annualized return of the S&P 400 TR USD was 9.49% between 2000 – 2019. While past performance is not indicative of future results, it’s important to understand how subsets of a particular asset class vary and the implications for your accounts.
Chart: Mid-Cap S&P 400 vs Large Cap S&P 500 Historical Returns (Ranked, 2000 – 2019)
Key takeaways on asset class diversification
- The stock market and the economy doesn’t always align. This boosts the case for diversification as the most effective way to reduce market risk.
- Developing your asset allocation is an exercise to balance risk and reward. The objective shouldn’t be to invest as aggressively as you ‘can’, rather taking on only as much risk as required to reach your goals.
- Diversification should run deep. Allocating a portfolio between stocks and bonds is usually just the beginning. Other considerations include real estate (REITs), geography, market capitalization, developed vs. emerging economies, sectors and industries, credit rating, cash balance, and so on.
- Depending on your account size, risk profile, and investment expertise, consider whether it’s better to invest using broad-based funds (e.g. Russell 3000) and/or customizing your exposure to select asset classes (e.g. S&P 400) and global markets. Having more control over your asset allocation by customizing your asset mix is often a good idea, but consider getting an advisor to help.
- Investment management is an ongoing process. Each year, review the percentages you allocate to each asset class. Also consider rebalancing as your investment mix is likely to shift as market values fluctuate. Rebalancing is the process of recalibrating your portfolio back to your initial desired asset class mix. Over the long term, as your goals become closer or your life stage changes, you may want to consider whether to take some risk off of the table by shifting the weightings of your main asset classes (e.g. stocks and bonds).