Asset allocation has become a popular buzzword, often used by investors but not fully understood. Why would anyone bother trying to build a portfolio that includes a wide variety of different financial assets? The answer is easy: a well-diversified portfolio will deliver a higher long-term return at a lower risk level than any of its components.
This result can be obtained even when very risky assets are added to a portfolio. Even though some assets may seem inappropriate to an investor when considered individually, in concert with other assets they can improve a portfolio’s performance.
The recent bear market has once again demonstrated the value of diversification, notes David G. Booth, chairman of Dimensional Fund Advisors, a mutual fund firm. In the three years ended in March, big American stocks, measured by the Standard & Poor’s 500 stocks index, lost 41%. Long-term Treasury Bonds, however, gained 38%, while very small stocks lost just 19%, he said. A stock investor who included small stocks and government bonds in her portfolio would have had a much better experience than an investor who just bought big American stocks.
New investors are often surprised to learn that combining risky assets with less risky assets can result in a lower overall risk level than any of the individual assets offers. For instance, suppose an investor were to combine domestic stocks and domestic bonds into a portfolio. Obviously, the bond market is not as risky as the stock market—its level of volatility is not as high. A portfolio solely of domestic stocks is more risky than a portfolio of domestic bonds. It stands to reason that any combination of the two would be less risky than stocks alone, but more risky than bonds.
Guess what? It is possible to construct portfolios with small amounts of stock and large amounts of bonds that have a lower risk level—and higher returns?than an investment in bonds alone. That happens because movements of bonds and stocks are not perfectly correlated. Sometimes they go up and down at the same rate while at other times they move in different directions. This lack of correlation means that when these two assets are combined, the resulting portfolio smoothes out the individual volatility of one or both of the assets.