Almost everyone knows that common stocks have generated the best long-term returns for investors. Why then, shouldn't you put everything you have into the stock market?
The short answer to that question is that stock prices go up, and they go down, sometimes in extreme ways. Hard experience has shown that it is very risky to be 100% invested in stock funds.
Stocks, which are shares of ownership in a business, are subject to a number of risks that can have an impact on your returns. The economy, inflation, interest rates, and market competition can all cause a company's value to rise or fall.
By the same token, you can't avoid risk by being invested 100% in bonds, which historically have generated lower returns than stocks with much less volatility. When interest rates rise, the value of some types of bonds can fall, and vice versa. Instead, it makes sense to diversify your retirement savings among stocks, bonds and cash investments, so that unexpected movements in any one asset class are offset by movements in others-potentially smoothing out your returns over time.
This strategy is called asset allocation. An asset allocation strategy can help you to accomplish three important goals:
- It can help you ride out market ups and downs
- It can let you adjust your exposure to risk
- It can let you add diversity investment holdings
One of the major benefits of combining stocks and bonds in one portfolio is that it helps smooth the negative effects of recessions on investment returns, like the one we've just experienced. Research from Vanguard, a well-regarded mutual fund company, shows that when stocks and bonds were combined into an equally weighted portfolio, the portfolio experienced less risk than stocks alone, and still achieved an average annual return of 5.26% in all recessions between 1926 and 2008.
Source: Joseph Davis, Ph.D and Daniel Piquet, "Recessions and balanced portfolio returns," Vanguard research, October 2011.
Performance was calculated using monthly nominal asset-class returns adjusted for inflation on the basis of monthly CPI data. Real monthly returns were used to calculate an annualized geometric return for recessionary periods as defined by the NBER. The hypothetical 50% stock/50% bond portfolio is rebalanced each month. Data from the BLS, the NBER, and index returns.
Michelle Maccio is the founder of the Maccio Financial Group. For more information, visit the company website at www.macciofg.com, or call (860) 426-1407.