Research

KnowRisk: Portfolio Diversification: The Role of Asset Allocation

The Role of Asset Allocation

What is Asset Allocation?
The asset-allocation decision is one of the most important factors in determining both the return and the risk of an investment portfolio.

Asset allocation is the process of developing a diversified investment portfolio by combining different assets in varying proportions.

An asset is anything that produces income or can be purchased and sold, such as stocks, bonds, or certificates of deposit. Asset classes are groupings of assets with similar characteristics and properties. Examples of asset classes are large-company stocks, long-term government bonds, and Treasury bills.

Every asset class has distinct characteristics and may perform differently in response to market changes. Therefore, careful consideration must be given to determine which assets you should hold and the amount you should allocate to each asset.

Factors that greatly influence the asset-allocation decision are your financial needs and goals, the length of your investment horizon, and your attitude toward risk.

Diversification REDUCES Risk, BUT does not eliminate the risk of investment losses

Reduction of Portfolio Risk
Diversification is the strategy of holding more than one asset class in a portfolio in order to reduce risk. This image depicts the relationship between portfolio volatility, measured by standard deviation, and the number of asset classes in a portfolio. Standard deviation measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns.

You can limit the effect that any individual security or asset class may have on the performance of a portfolio by investing in a combination of asset classes. As a result, declines in the total returns of one or two assets may be offset by increases in others. Notice that as the number of randomly selected assets in the portfolio increases, the risk level decreases. While it is impossible to completely eliminate risk, diversifying your investments can reduce the overall volatility experienced by your portfolio.

Past performance is no guarantee of future results. Risk is measured by standard deviation. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Potential to Reduce Risk or Increase Return 1970–2008
Historically, adding stocks to a portfolio of less volatile assets reduced risk without sacrificing return or increased return without assuming additional risk.

The graph below illustrates the risk-and-return profiles of three hypothetical investment portfolios. The lower risk portfolio, which included stocks, had the same return as the portfolio comprised entirely of fixed-income investments, but assumed less risk. The higher return portfolio had the same risk level as the fixed income portfolio, but produced an increased return.

Although it may appear counterintuitive, diversifying a portfolio of fixed-income investments to include stocks reduced the overall volatility of a portfolio during the period 1970–2008. Likewise, it is possible to increase your overall portfolio return without having to take on additional risk.

Because stocks, bonds, and cash generally do not react identically to the same economic or market stimuli, combining these assets can often produce a more appealing risk-and-return tradeoff.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. They are based on annual data over the period 1970–2008. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Effective diversification requires combining assets that behave differently

The Case for Diversifying
Diversifying your portfolio makes you less dependent on the performance of any single asset class.

Effective diversification requires combining assets that behave differently when held during changing economic or market conditions. Moreover, investing in assets that have dissimilar return behavior may insulate your portfolio from major downswings.

The graph above illustrates the annual returns of three different portfolios over a seven-year time period. Stocks represent a 100% investment in large-company stocks. Bonds represent a 100% investment in long-term government bonds.

When the stock and bond asset classes were combined into an equally weighted portfolio, the portfolio experienced less volatility than stocks alone and still maintained an attractive return. Notice that stock returns were up at times when bond returns were down, and vice versa. These offsetting movements assisted in reducing portfolio volatility (risk).

Past performance is no guarantee of future results. Time period illustrated is from 1956–1962. This time period was chosen as a dramatic illustration of stock and bond return behavior and how their often opposite movements reduced portfolio volatility. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

“The Free Lunch”

Stocks and Bonds: Risk Versus Return 1970–2008
An efficient frontier represents every possible combination of assets that maximizes return at each level of portfolio risk and minimizes risk at each level of portfolio return. An efficient frontier is the line that connects all optimal portfolios across all levels of risk. An optimal portfolio is simply the mix of assets that maximizes portfolio return at a given risk level. This image illustrates an efficient frontier for all combinations of two asset classes: stocks and bonds.

Although bonds are considered less risky than stocks, the minimum risk portfolio does not consist entirely of bonds. The reason is that stocks and bonds are not highly correlated; that is, they tend to move independently of each other. Sometimes stock returns may be up while bond returns are down, and vice versa. These offsetting movements help to reduce overall portfolio volatility (risk).

As a result, adding just a small amount of stocks to an all-bond portfolio actually reduced the overall risk of the portfolio. However, including more stocks beyond this minimum point caused both the risk and return of the portfolio to increase.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. They are based on annual data over the period 1970–2008. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

More Assets Do Not Always Mean Greater Diversification

Holdings-based style analysis can be used to determine security overlap
The graphs below illustrate two different equity portfolios that individually comprise four mutual funds. Each oval within the style box represents an ownership zone of a mutual fund, which accounts for 75% of the fund’s holdings. The level of diversification provided by each portfolio is quite different.

The funds in Portfolio A significantly overlap with one another, which indicates that each fund may hold stocks sharing similar style characteristics. While some overlap is acceptable in a portfolio, too much of it defeats the purpose of using multiple funds to create a diversified portfolio. In contrast, Portfolio B contains funds that span across many different styles. While the holdings in Portfolio A are more concentrated in the giant and large-cap value and blend segments, the holdings in Portfolio B are widely distributed among different investment styles.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. They are based on annual data over the period 1970–2008. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. The investment style matrix was designed by and is the copyrighted property of Morningstar, Inc.

Asset-Class Winners and Losers
It is impossible to predict which asset class will be the best or worst performing in any given year. The performance of any given asset class can have drastic periodic changes. The table below illustrates the annual performance of various asset classes in relation to one another over the past 15 years. In times when one asset class dominates all others, as was the case for large stocks in the late 1990s, it is easy to ignore the fact that historical data shows it is impossible to predict the winners for any given year.

Investors betting on another stellar performance for large stocks in 1999 were certainly disappointed as small stocks rose from the worst performing asset class in 1998 to the best performing in 1999. Similarly, international stocks were the top performers from 2004 to 2007, but disastrously sank to the worst performing position in 2008. These types of performance reversals are evident throughout this example. A well-diversified portfolio may allow investors to mitigate some of the risks associated with investing. By investing a portion of a portfolio in a number of different asset classes, portfolio volatility may be reduced.

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Correlation can help evaluate Potential diversification benefits

A well-diversified portfolio should consist of individual investments that behave differently.

It is possible to determine how closely two asset classes move together by evaluating their correlation. Correlation ranges from –1.00 to 1.00, with –1.00 indicating that the returns move perfectly opposite to one another, 0.00 indicating no relationship, and 1.00 indicating that the asset classes react exactly the same.

For example, small stocks and large stocks have risen and fallen to the same market conditions. Their high correlation suggests combining them may do little to lower the risk of a portfolio.

In contrast, the negative correlation of small stocks and intermediate-term government bonds illustrates the potential for better diversification. Investments still need to be evaluated for investor suitability, but understanding asset class behavior may help enhance the diversification benefits of investor portfolios.

 

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Diversification in Bull and Bear Markets
Diversification is the strategy of combining distinct asset classes in a portfolio in order to reduce overall portfolio risk.

The graph on the left illustrates the hypothetical growth of $1,000 in stocks, bonds, and a 50% stock/50% bond diversified portfolio, from 2002 to 2007. Stocks provide increased growth in bull markets. It is important to understand, however, that this greater wealth was achieved with considerable volatility in stocks compared to the diversified portfolio.

The significance of holding a diversified portfolio is most apparent when one or more asset classes are out of favor. The graph on the right illustrates the hypothetical growth of $1,000 in stocks, bonds, and in a diversified portfolio, between 2007 and 2008.

Notice that by diversifying among the two asset classes, the diversified portfolio experienced less severe monthly fluctuations than stocks or bonds alone. While bond prices tend to fluctuate less than stock prices, they are still subject to price movement. By investing in a mix of asset classes such as stocks, bonds, and Treasury bills, you may insulate your portfolio from major downswings in a single asset class. One of the main advantages of diversification is that it makes you less dependent on the performance of any single asset class.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Diversification can limit your losses during a severe market decline

Diversified Portfolios and Bear Markets
The benefits of diversification are most evident during bear markets. The graph below illustrates the growth of stocks versus a diversified portfolio during two of the worst performance periods in recent history.

The blue line illustrates the hypothetical growth of $1,000 invested in stocks during the mid-1970s recession and the 2007–2008 bear market. The red line illustrates the hypothetical growth of $1,000 invested in a diversified portfolio of 35% stocks, 40% bonds, and 25% Treasury bills during these same two periods.

Over the course of both time periods, the diversified portfolio lost less than the pure stock portfolio. Over longer periods of time, the more volatile single asset-class portfolio is likely to outperform the less volatile diversified portfolio. However, you should keep in mind that one of the main advantages of diversification is reducing risk, not necessarily increasing return, over the long run.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.