[See How to Keep Your Cool in a Turbulent Market.]
Diversify within asset classes. The so-called "lost decade for stocks" makes a good case for diversification. If you had invested only in an index fund that tracks the S&P 500 over the period starting Jan. 1, 2000, and ending Dec. 31, 2009, you would have earned virtually nothing. The culprit? Large-cap stocks that performed poorly during this time period. Meanwhile, other asset classes provided a solid return. For instance, over the past 10 years the Russell 2000 (a small-cap index) has returned an annualized 4 percent.
[See 3 Ways to Invest in the Small Cap Rally.]
Keep an eye on cross-asset allocation. Large cap? Small cap? Those distinctions matter, but not nearly as much as the mix of different classes of assets in your portfolio. And it's not just stocks and bonds anymore that make up a truly diversified portfolio. Experts now say equities and fixed income should be held side-by-side with a raft of assets, including real estate, commodities, and other alternative investments in an attempt to prevent just the sort of damage that hit portfolios during the 2008-2009 crisis, when wide swaths of assets (homes, stocks, bonds) all lost value at the same time. Research shows that almost all investment volatility is driven by asset allocation decisions—how you carve out investments among stocks, bonds, real estate, international investments, and commodities. A classic study of pension funds showed that 91.5 percent of investment variation in quarterly returns is explained by investment policy rather than stock picking or other factors. "It's not so much what you put in your account, it's how you allocate what you put in your account that's going to help reduce volatility," says Brian Rimel, an adviser with Raymond James.
[See 3 Ways to Invest in the Real Estate Rally.]
Rebalance periodically. It's important to monitor your portfolio and make sure your asset allocation changes over time, says Benz. "Making the judgment about what is an appropriate stock, bond, and cash mix, and also taking care to adjust that over time as you get closer to needing your money is a hugely important and impactful step—arguably more important than individual security selection," Benz says. Some experts recommend that younger investors fill their portfolio entirely with stocks, then begin to shift into other types of investments, like bonds, as they get older. Benz recommends target-date funds, in which a manager handles the asset allocation through a set retirement date. Fund families often employ different "glide paths"—or asset allocation that changes over time. As you approach retirement, target-date funds generally shift to a more conservative mix over time. If you decide to choose your own funds, remember to rebalance periodically.
[See Why Not All Target-Date Funds Are Created Equal.]
Don't try to time the market. It's a common investing error: buying funds when they're flying high and dumping them when they fall behind. Over the past decade, Morningstar research has shown that investors simply aren't successful in timing the market. To illustrate, Morningstar calculates what it calls investor returns, which reveal how much money actual investors actually make or lose in a fund based on when they buy and sell. The difference can be huge. Many individual investors do a poor job of timing the markets and tend to lose more in funds than the actual returns show. Take Janus Twenty. It's a large-growth fund that ranks in the top half of its category over the past 10 years that has lost 2 percent per year, on average. According to Morningstar, investors in the fund, on average, lost an annualized 7 percent over that time period because they jumped in and out at the wrong times. Research has shown that the most volatile funds in the most volatile categories, where big swings in returns can make for a wild ride, have the worst investor returns when compared to average reported returns. "We tend to see with the more extreme types of funds that those are the funds where investors badly mishandle their timing decisions, so the more volatile the fund category the more likely you are to see a pattern of investors foregoing gains because they timed their purchases poorly," Benz says. For all categories, over the past decade, the average investor returns among funds representing all asset classes have been about 1.5 percentage points lower than the funds' average reported returns, according to Morningstar's research.
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