Create an Asset Mix Using Diversification and Your Target Portfolio

It’s important to allocate your investments across asset classes. However, diversification doesn’t mean you have to make it complicated.

Consider a portfolio that has investments in these asset classes:
U.S. Large-Cap Stock Fund
Foreign Funds, including emerging markets
U.S. Small-Cap Stock Fund
Value Fund
Bond Fund
Inflation-Protected Bond Fund
Money-Market Fund

One of the most important things you can do to protect your portfolio from volatility and down markets is to diversify. While it won’t guarantee you won’t have losses, it can help limit them and control day-to-day volatility and risk.

Analysis shows that a properly diversified portfolio performs better (i.e. loses less) than a non-diversified portfolio during times of market stress.

Diversification isn’t just owning a couple of stocks or a mutual fund. There’s more to it than that. Here are two key aspects of it and how to apply them to your portfolio.

1. Create the right investment mix

Having an appropriate mix of investments—also known as asset allocation—can be a critical factor in the overall performance of your portfolio. Asset allocation is straightforward: You spread your money among different types of investments, or asset classes, such as U.S. and international stocks, bonds, and short-term investments. Historically certain types of investments have tended to move in opposite directions, i.e., they are negatively correlated. So if parts of your portfolio are declining, others may be growing. In turn, the overall impact of poor market performance on your portfolio may be dampened.

How you determine your asset allocation largely depends on your comfort with risk and the time frame for your investments. Generally, the younger you are, the more risk you can afford to take with your retirement investments. As you get older and closer to retirement, you may be less interested in growth and more interested in protecting the value of your portfolio. As you reach retirement age this becomes even more important since a large decline in the value of your holdings can affect your retirement lifestyle.

Here are six target asset mixes—based on risk—ranging from more conservative to most aggressive. You can choose the one that’s appropriate for your situation.

2. Diversify within asset classes

The next step is to diversify within the investment categories—U.S. and international stocks, bonds, and short-term investments. For instance, stocks vary according to company size (large cap, mid cap, small cap), style (growth stocks, value stocks), sector (technology, biotech, financials, etc.), and geography (domestic, international developed, international emerging markets). Bonds vary according to their maturity (short-term, intermediate-term, long-term), credit quality (investment grade bonds, high yield bonds), or issuer (government, corporate, municipal bonds).

Asset classes generally don’t move in lockstep and performance can vary widely—as the table below shows. No one can predict with certainty which will be the next leader. While it cannot ensure a profit or guarantee against a loss, diversification allows an investor to seek some downside protection and participate in the upside potential of asset class movements.

Are you diversified?

Now that you have a sense of how to diversify, you need to determine if your current portfolio is positioned properly. One way is to compare your holdings to a benchmark. For example, each asset class in the target portfolios shown above is tied to a benchmark index that represents a specific asset class:
U.S. stocks: Dow Jones U.S. Total Stock Market Index, a broad index that intends to measure the performance of all publicly traded companies in the U.S.
International stocks: MSCI EAFE® Index, an index of foreign stocks with a U.S. perspective, which includes stocks from 21 developed markets, not including Canada and the U.S.
Bonds: Barclays Capital U.S. Aggregate Bond Index, an index of U.S. securities in Treasury, government-related, corporate, and securitized sectors.
Short term: Barclays Capital 3-Month U.S. Treasury Bill Index, an index of investment grade publicly issued zero-coupon treasury bills that are maturing in 1-3 months. Excludes special issues, such as state and local government series bonds and treasury inflation-protected securities (TIPS).

The Growth target portfolio shown above is 60% in U.S. stocks as measured by the Dow Jones U.S. Total Stock Market Index; 10% in international stocks measured by the EAFE Index; 25% in bonds tied to the Barclays Bond Index; and 5% in short term represented by the Barclays 30-day Treasury Index.

Each benchmark index is comprised of stocks or bonds spread across different sectors. For example, the Dow Jones U.S. Total Stock Market Index is comprised of stocks in 13 sectors, including hardware (10.1%), health care (12.92%), consumer services (9.11%), financial services (12.73%), industrial materials (11.48%), and energy (11.96%). The percentages represent how much of the index is in the category.

You can compare your current holdings in an asset class to the weightings of its benchmark. For example, if you own Exxon Mobil, it would be represented in the energy sector in the Wilshire 5000. Additionally, if you own mutual funds or exchange traded funds (ETFs), you would look at the underlying investments within the fund, and compare those to the benchmark. By comparing your portfolio to a benchmark, you can identify areas in which you are over or underweighted. If you’re overweighted in an area, you may want to consider selling some of your investments in order to align more with the benchmark. If you’re underweighted, you may want to consider increasing your exposure.

What to do

There are resources on the internet to help you analyze your portfolio and suggest changes.

If you don’t feel like you have the time or experience to tackle diversification on your own, there are other options:

Consider a “target fund” which serves as a single-fund solution. These funds automatically rebalance the asset mix—from aggressive to conservative—as the fund gets closer to its target date. You choose the fund with the target date closest to when you want to retire.

Have a trekking guide help you recommend an asset mix. An investment professional can select a diversified group of funds for your portfolio, and manage it on an ongoing basis.

Related Activities and Side Trips

• Asset Allocation Myths
• Diversification and Our Emotions
• Diversification at Harvard
• Every Investor Should Have Investment Rules for Asset Allocation and Rebalancing
• Index Funds – All In or All Out
• Index Funds and the Efficient Market Hypothesis
• Index Funds, Tax-Managed Funds and ETFs – Low-Cost, Diversified
• Use an ETF to Build Net Worth