Investment Diversification is a powerful tool in financial markets. It can help you reduce risk without significantly diminishing returns. For proof, let’s look at the long-term returns of the two main asset classes, U.S. stocks and bonds. For U.S. stocks, we will use the S&P 500 while for bonds, we will use intermediate-term U.S. Treasury Bonds. By intermediate, I mean those with a maturity of about five years. Information about U.S. Treasury Bonds can be found here.
A Brief History of Financial Markets
In the 47 years from 1968 through 2015, the S&P 500 returned 9.8% on an annualized basis. This compares to 7.2% for bonds. At first glance, it may seem like a good idea to put all of your money into stocks. To see why this might be a mistake, we must first have an understanding of risk. That 9.8% return for stocks came with tremendous volatility, such as a negative 37% return in 2008. In fact, stocks lost more than 5% in 8 out of 47 years. That only happened once for bonds. Another way to measure risk is with standard deviation. Stocks had a standard deviation of 17%, more than twice that of bonds. So while bonds had a lower return than stocks, they were indeed less risky.
Here is where investment diversification comes into play. Stocks and bonds don’t typically move in the same direction. In fact, in 2008—the year that stocks lost 37%–bonds gained 13%. We call this correlation and stocks and bonds are nearly uncorrelated. In other words, when stocks zig, bonds zag.
Combining Stocks and Bonds
Now, if we combine stocks and bonds into a portfolio, we might get returns similar to the all-stock portfolio but with less risk. Indeed that is what we find. A portfolio of 80% stocks and 20% bonds had a return of 9.6% but a standard deviation of 14%. That gets us 98% of the return of the all-stock portfolio but only 80% of the risk.
If we want to cut risk even further, we can build a 60/40 portfolio with 60% of the assets in stocks and the remainder in bonds. This portfolio yields 93% of the return of the all-stock portfolio with only 63% of the risk. In addition, this portfolio fell only 17% in 2008, much better than the 37% loss of the all-stock portfolio.
Build It For Me
A 60/40 portfolio has long been an investing rule of thumb. Those who think this is an appropriate mix might consider buying Vanguard Balanced Index Fund symbol VBIAX. This fund maintains a 60/40 mix by re-balancing between two indexes, one representing all U.S. stocks and the other covering nearly the entire U.S. bond market. By owning this fund you will automatically have a solid investment diversification in place.
A more dynamic rule of thumb suggests putting an amount into bonds equal to your age. This way, a young invest will have most of his money in stocks, but this will gradually shift to less risky bonds as the investor approaches retirement. This shift is called the glide path. Investors looking for one fund to manage their glide path over time might consider a target-date fund like Vanguard, T. Rowe Price or others offer. Check Vanguard’s target date fund here.