The Power of Diversification

Financial advisors and their clients are in control of two powerful factors that can help meet retirement goals: the amount of money to save and diversifying those savings to balance potential growth and risk. An important part of diversification is choosing the right combination of asset classes for your clients. By some estimates, the mix of stocks, bonds, and other assets in a client’s portfolio is responsible for 90% of long-term returns.¹ In the face of market fluctuations, inflation, and life’s uncertainties, properly diversifying assets represents one of the most important strategies an advisor can use to help clients develop a retirement plan.

Advisors should work closely with clients to fully explore the potential benefits of diversification and then create a customized asset mix for their individual needs. Here is a closer look at some key factors that can help align diversification decisions with each client’s retirement goals and risk tolerance.

Reducing the Impact of Short-term Market Declines Can Improve Long-term Returns

Long-term wealth creation is a goal for many clients, but pursuing higher returns is only half of the equation. Advisors and their clients should also consider the impact of market volatility on long-term results.

Taking on market risk is necessary for growth potential. We see this in historical market data that shows how riskier assets have higher potential returns: Since 1926 (the earliest that reliable data is available for domestic equity markets), large-cap stocks have generated much higher compound annual returns than bonds — 10.0% compared to 5.5%. Even within equities, riskier small-cap stocks have outpaced more conservative large-cap stocks, delivering a 12.1% compound annual return over the same period.²

But riskier assets also carry a greater risk of losses, making short-term downturns in one’s portfolio inevitable in the pursuit of long-term gains. That’s why it’s important to consider the potential impact of downturns on a decades-long investing strategy. As we see in this chart, the gains required for a portfolio to fully recover from a downturn increase with the magnitude of the loss. For example, a 20% loss requires a 25% gain just to break even, while a 30% loss requires a 43% gain to break even, a 50% loss requires a 100% gain to break even, and so on. In short, it takes an increasingly higher gain to offset a larger loss, making it paramount to try and avoid these losses in the first place.

Gain Required To Fully Recover From A Loss

The situation compounds when clients are also making withdrawals from their investment portfolios: A client withdrawing 5% annually from their savings over five years would need a cumulative gain of 82% before their savings recovered their value after a 20% decline.³

Having too much of one’s wealth in one type of asset can increase the risk of steep declines that require lengthy recoveries. Consider this example from the 2008 financial crisis: $100,000 invested in the S&P 500 would have lost half its value from October 2007 to March 2009 — the market’s low point during the recession. It would be four long years before that investment recovered its losses. What’s more, in the face of such a major market setback, many investors sold their stocks, losing the opportunity to participate in the recovery.

On the other hand, $100,000 invested in a mix of 60% stocks and 40% bonds would have declined to only around $70,000 between October 2007 and March 2009. That portfolio would have recovered more than a year earlier, in February 2012, putting investors through less stress and a lower temptation to abandon their stock investments.

Impact Of Losses And Recovery Time

Smaller declines and quicker recoveries allow portfolios to start growing again sooner, helping a diversified portfolio achieve similar returns as a concentrated portfolio but with less volatility.

Broadening Diversification for Greater Protection

There are ways to enhance the benefits of diversification. One approach is to take advantage of a broader range of investment products beyond IRAs, 401(k)s and other traditional investment accounts — this is known as product diversification. Another strategy is to strengthen investment diversification by broadening a portfolio’s mix to include more asset classes.

Clients may not fully realize that the investment universe is much bigger than just the S&P 500 and investment-grade corporate bonds — and that these asset classes often react differently to prevailing economic and market factors, sometimes dramatically. As a result, returns from each asset class vary widely from year to year, as we see in this chart. The top-performing asset class one year could be the lowest-performing class the next year, and vice versa.

Asset Class Annual Returns: 2001-2017

Because each asset class’s returns are driven by different factors — including their inherent risk and their different levels of sensitivity to economic factors such as interest rates, inflation, and commodity prices — no single asset class outperforms the others consistently. What’s more, certain assets tend to move in the same direction at the same time, known as correlation. Others tend to move in opposite directions at the same time and are considered non-correlated.

Diversification that takes into account different returns and correlation patterns can help even out the fluctuations in investment returns over time. Diversified portfolios can capture the gains available in different areas of the market and mitigate risks from the poor performance of certain asset classes at different points in the market cycle. For example, a client’s equity allocation might be spread among large-cap, mid-cap, and small-cap stocks that may perform differently in the same year; adding exposure to international investments may help portfolios weather downturns in domestic markets; and high-yield bonds can provide an alternative to investment-grade corporate bonds.

Portfolios that are more broadly diversified in this way tend to have better risk/return profiles than less broadly diversified portfolios over long economic and market cycles. A study by J.P. Morgan Asset Management found that a portfolio invested only in three asset classes (large U.S. stocks, international developed market stocks, and U.S. investment-grade bonds) delivered a 6.4% return from 2001–2016, with 12.0% volatility. On the other hand, a portfolio invested in eight asset classes, including large and small stocks, real estate, emerging market equities, and high-yield bonds, would have delivered a 7.2% return during the same years, with just 11.1% volatility.⁴

There are limits to diversification’s effectiveness, however, and advisors and clients should avoid becoming too diversified — a phenomenon known in the industry as “de-worse-ification.” Purchasing too many different mutual funds targeting the same general asset categories, for example, may result in higher costs or hidden concentrations that increase risk. Instead, investors should focus on achieving exposure to broad asset classes, while considering the optimal balance of risk, potential return, and low-correlation of returns with their advisor. (You can explore diversification strategies more deeply on our Client Insights page).

At Brighthouse Financial, we understand how important it is to diversify retirement savings, which is why we offer a range of financial products with carefully chosen investment options to help pursue growth and manage risk. The power of diversification is that the concept can work for a large range of clients, because diversification is flexible enough to allow for portfolios that align with each client’s goals and risk tolerance. Advisors who embrace the opportunities for deeper and broader diversification will be positioned to develop retirement strategies that help keep clients on track to achieve their long-term goals.