If you lose 50% on an investment, you have to make a return of 100% going forward in order to recoup the original 50% loss. You would need your % gain to be twice as much as your % loss, to be at break even. For this reason, professional investors spend a tremendous amount of time trying to avoid major losses. One of the primary tools to avoid major losses is diversification.
Diversification simply means don’t keep all your eggs in one basket. While diversification cannot protect you from the overall market, it can protect you from a few bad investment decisions destroying your portfolio “nest egg”. Diversification reduces the chance that something that effects a small portion of the market will have a major impact on your portfolio.
Here is a major myth about diversification: If you own several different stocks, you have a diversified portfolio. True diversification means that you have a mix of asset classes, including both stocks and bonds.
The prices of individual stocks tend to mover together. There is a saying, “A rising tide lifts all boats.” When the market is rising, all stocks tend to rise. Some stocks will due better than the average stock based on their unique attributes, and some will lose money, but a portion of the performance of all stocks has to due with the overall market. If the stock market as a whole experiences a large drop in value, then it is highly likely that the stocks you have invested in will also experience a loss (or at a minimum a lower return than would have otherwise been the case).
One of the best advantages of the bond market is that it has a low correlation with the stock market. This means that generally when the stock market as a whole is losing value, the bond market as a whole is gaining in value, and vice versa. With this in mind, placing some of your money in stocks and some of your money in bonds can provide a nice “smoothing” of your returns, and help you avoid large swings that can be detrimental to the long term value of your portfolio.
When holding bonds or other types of fixed income instruments to maturity, there is also a level of certainty that does not exist with stocks. The consistent income generated by the portion of your portfolio held in the bond market can provide a lot of comfort during the periods when the money you have in the stock market is experiencing losses. This is important not only from a psychological standpoint, but also if you rely on the income from your investments to cover expenses.
Whether you allocate more or less of your money to fixed income products will depend largely on your “time horizon” for investment. This is the time period between the start of your investment and moment when you’ll want to start spending the profit it generates. Younger people may have longer time horizons; a 30 year old planning for retirement at the age of 65 has a 35 year time horizon. In this case, an investor may decide to invest more in products with a higher risk and return profile (like stocks). These products have historically out performed bonds, but have greater price volatility. Longer holding periods (like decades) can lessen the impact of market volatility on the final return. As a result, a younger person is in a better position to “tolerate” short term swings in market performance.
A person approaching retirement age may want to insulate themselves from market swings. Additionally, they may want to re-allocate their portfolio to have more income generating products, as the may want to be able to take money out of their account without touching the principal. People tend to switch from having a stock heavy to bond heavy portfolio starting in their 50s.
One guideline for how much to allocate to bonds or other fixed income products is to convert your age directly to the percentage of fixed income products you should hold. For example, if you’re 30, then allocate 30% of your investment to fixed income products, and if you’re 60, then allocate 60%.