Principle 2: Develop a suitable asset allocation using broadly diversified funds
A sound investment strategy starts with an asset allocation suitable for the portfolio's objective.
The allocation should be built upon reasonable expectations for risk and returns, and should use diversified investments to avoid exposure to unnecessary risks.
Both asset allocation and diversification are rooted in the idea of balance. Because all investments involve risk, investors must manage the balance between risk and potential reward through the choice of portfolio holdings.
Here we provide evidence that:
- A diversified portfolio's proportions of stocks, bonds, and other investment types determine most of its return as well as its volatility.
- Attempting to escape volatility and near-term losses by minimizing stock investments can expose investors to other types of risk, including the risks of failing to outpace inflation or falling short of an objective.
- Realistic return assumptions—not hopes—are essential in choosing an allocation.
- Leadership among market segments changes constantly and rapidly, so investors must diversify both to mitigate losses and to participate in gains.
The importance of asset allocation
When building a portfolio to meet a specific objective, it is critical to select a combination of assets that offers the best chance for meeting that objective, subject to the investor's constraints.2 Assuming that the investor uses broadly diversified holdings, the mixture of those assets will determine both the returns and the variability of returns for the aggregate portfolio.
This has been well documented in theory and in practice. For example, in a paper confirming the seminal 1986 study by Brinson, Hood, and Beebower, Wallick et al. (2012) showed that the asset allocation decision was responsible for 88% of a diversified portfolio's return patterns over time:
Investment outcomes are largely determined by the long-term mixture of assets in a portfolio
Note: Calculations are based on monthly returns for 518 U.S. balanced funds from January 1962 through December 2011. For details of the methodology, see the Vanguard research paper The Global Case for Strategic Asset Allocation (Wallick et al., 2012).
Source: Vanguard calculations using data from Morningstar.
In the illustration below we show a simple example of this relationship using two asset classes—U.S. stocks and U.S. bonds—to demonstrate the impact of asset allocation on both returns and the variability of returns. The middle numbers in the chart show the average yearly return since 1926 for various combinations of stocks and bonds. The bars represent the best and worst one-year returns. Although this example covers an unusually extended holding period, it shows why an investor whose portfolio is 20% allocated to U.S. stocks might expect a very different outcome from an investor with 80% allocated to U.S. stocks.
Stocks are risky—and so is avoiding them
Stocks are inherently more volatile than investments such as bonds or cash instruments. This is because equity owners are the first to realize losses stemming from business risk, while bond owners are the last. In addition, whereas bond holders are contractually promised a stated payment, equity holders own a claim on future earnings. But the level of those earnings, and how the company will use them, are beyond the investor's control. Investors thus must be enticed to participate in a company's uncertain future, and the "carrot" that entices them is higher expected or potential return over time.
The chart below also demonstrates the short-term risk of owning stocks: Even a portfolio with only half its assets in stocks would have lost more than 20% of its overall value in at least one year. Why not simply minimize the possibility of loss and finance all goals using low-risk investments? Because the attempt to escape market volatility associated with stock investments by investing in more stable, but lower-returning, assets such as Treasury bills can expose a portfolio to other, longer-term risks.
The mixture of assets defines the spectrum of returns:
Best, worst, and average returns for various stock/bond allocations, 1926–2012
Note: Stocks are represented by the Standard & Poor's 90 Index from 1926 to March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Wilshire 5000 Index from 1975 through April 22, 2005; and the MSCI US Broad Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1926 to 1968; the Citigroup High Grade Index from 1969 to 1972; the Barclays U.S. Long Credit AA Index from 1973 to 1975; and the Barclays U.S. Aggregate Bond Index thereafter. Data are through December 31, 2012. Source: Vanguard.
One such risk is "opportunity cost," more commonly known as shortfall risk: Because the portfolio lacks investments that carry higher potential return, it may not achieve growth sufficient to finance ambitious goals over the long term. Or it may require a level of saving that is unrealistic, given more immediate demands on the investor's income or cash flow (in the case of an endowment or pension fund, for example). Another risk is inflation: The portfolio may not grow as fast as prices rise, so that the investor loses purchasing power over time. For longer-term goals, inflation can be particularly damaging, as its effects compound over long time horizons. For example, Bennyhoff (2009) showed that over a 30-year horizon, an average inflation rate of 3% would reduce a portfolio's purchasing power by more than 50%.
For investors with longer time horizons, inflation risks may actually outweigh market risks, often necessitating a sizable allocation to investments such as stocks.
Use reasonable assumptions in choosing an allocation
Just as important as the combination of assets that are used to construct a portfolio are the assumptions that are used to arrive at the asset allocation decision. By this we mean using realistic expectations for both returns and volatility of returns. Using long-term historical data may serve as a guide, but investors must keep in mind that markets are cyclical and it is unrealistic to use static return assumptions. History does not repeat, and the market conditions at a particular point in time can have an important influence on an investor's returns.
For example, over the history of the capital markets since 1926, U.S. stocks returned an average of 10.0% annually and U.S. bonds 5.5% (based on the same market benchmarks used in the illustration above). For this 86-year period, a half-stock, half-bond portfolio would have returned 8.3% a year on average if it matched the markets' return.
But look at a shorter span, and the picture changes. For example, from 1980 through 2012, U.S. stocks returned an average of 11.1% a year, while bonds returned 8.5%. A portfolio split evenly between the two asset classes and rebalanced periodically would have generated an average annual return of 10.2%. As you can see, anyone with such a portfolio over this particular period could have earned nearly 2 percentage points a year more than the long-term historical average. Contrast that with the period from 2000 through 2012, when U.S. stocks provided a 2.3% average return and U.S. bonds 6.3%; then the same balanced portfolio would have averaged 4.9% a year.
In practice, investors will always need to decide how to apply historical experiences to current market expectations. For example, as reported in Vanguard's 2013 Economic and Investment Outlook, returns over the next decade may look very different from the examples above as a result of current market conditions. Particularly for bonds, the analysis provided in the paper suggests that returns may be lower than what many investors have grown accustomed to. The implication is that investors may need to adjust their asset allocation assumptions and contribution/spending plans to meet a future objective that could previously have seemed easily achievable based on historical values alone.
Diversify to manage risk
Diversification is a powerful strategy for managing traditional risks.3 Diversifying across asset classes reduces a portfolio's exposure to the risks common to an entire class. Diversifying within an asset class reduces exposure to risks associated with a particular company, sector, or segment.
In practice, diversification is a rigorously tested application of common sense: Markets will often behave differently from each other—sometimes marginally, sometimes greatly—at any given time. Owning a portfolio with at least some exposure to many or all key market components ensures the investor of some participation in stronger areas while also mitigating the impact of weaker areas. See for example Figure 6 on page 13 of the PDF of this article, where we show annual returns for a variety of asset and sub-asset classes. The details of Figure 6 don't matter so much as its colorful patchwork, which shows how randomly leadership can shift among markets and market segments.
Performance leadership is quick to change, and a portfolio that diversifies across markets is less vulnerable to the impact of significant swings in performance by any one segment. Investments that are concentrated or specialized, such as REITs, commodities, or emerging markets, also tend to be the most volatile. This is why we believe that most investors are best served by significant allocations to investments that represent broad markets such as U.S. stocks, U.S. bonds, international stocks, and international bonds.
Although broad-market diversification cannot insure an investor against loss, it can help to guard against unnecessarily large losses. One example: In 2008, the Standard & Poor's 500 Index returned –37%. However, more than a third of the stocks in the index that year had individual returns worse than –50%.4 Some of the worst performers in the index would probably have been viewed as "blue chip" companies not long before. They were concentrated in the financial sector, considered a staple in many dividend-focused portfolios:
The ten worst and best stocks in the S&P 500 Index in 2008
Sources: FactSet and Vanguard.
Although this example comes from the stock market, other asset classes and sub-classes can provide many of their own. It's worth saying again that, while diversification cannot insure against loss, undiversified portfolios have greater potential to suffer catastrophic losses.
The key take-away
Asset allocation and diversification are powerful tools for achieving an investment goal. A portfolio's allocation among asset classes will determine a large proportion of its return—and also the majority of its volatility risk. Broad diversification reduces a portfolio's exposure to specific risks while providing opportunity to benefit from the markets' current leaders.
1. For asset allocation to be a driving force of an outcome, one must implement the allocation using vehicles that approximate the return of market indexes. This is because market indexes are commonly used in identifying the risk and return characteristics of asset classes and portfolios. Using a vehicle other than one that attempts to replicate a market index will deliver a result that may differ from the index result, potentially leading to outcomes different from those assumed in the asset allocation process. To make the point with an extreme example: Using a single stock to represent the equity allocation in a portfolio would likely lead to very different outcomes from either a diversified basket of stocks or any other single stock.
2. Diversification carries no guarantees, of course, and it specifically may not mitigate the kinds of risks associated with illiquid assets, counterparty exposure, leverage, or fraud.
3. We believe that if international bonds are to play an enduring role in a diversified portfolio, the currency exposure should be hedged. For additional perspective, including an analysis of the impact of currency on the return characteristics of foreign bonds, see Philips et al. (2012).
4. A 50% loss requires a 100% return to break even, while a 37% loss requires a 59% return to break even.
- All investing is subject to risk, including possible loss of principal.
- Past performance does not guarantee future results.
- There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- Diversification does not ensure a profit or protect against a loss in a declining market.
- Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
- Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
- Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
- The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
- Data source for the interactive illustration above: Vanguard. Stock returns are represented by the Standard & Poor's 500 Index (1926–1970), Dow Jones Wilshire 5000 Index (1971–April 22, 2005), and MSCI US Broad Market Index thereafter. Bond returns are represented by the S&P High Grade Corporate Index (1926–1968), Citigroup High Grade Index (1969–1972), Lehman Brothers U.S. Long Credit AA Index (1973–1975), and Barclays Capital U.S. Aggregate Bond Index thereafter. Cash is represented by the Citigroup 3-Month Treasury Bill Index. Returns are adjusted for inflation. Data shown here do not represent any particular portfolio or recommended asset mix.