Diversification Among Asset Classes

Although diversification can reduce risks, it can’t be trusted to eliminate all the risks. It can minimize asset-specific risk i.e., the risk that comes from the ownership of too many stocks of one company (of Walmart, for example) or stocks in general.

However, it can’t eliminate the market risk which comes from simply owning that asset at all.

For instance, diversifying your assets will limit the losses on your portfolio if the price of some stocks falls. But it won’t shield you if the investors decide to punish the entire industry. Thus, diversification will shield you against asset-specific risk but it has no control over market-specific risk.

This is where diversification across multiple asset classes comes into the picture i.e., bonds, stocks, and cash. Studies reveal that a majority of the variations in a portfolio’s return are a direct outcome of multiple asset class allocations.

Investors can minimize the risk of any major decline in their portfolio by including multiple asset classes like short-term bonds, long-term bonds, intermediate-term bonds, U.S. small-cap stocks, large-cap stocks, and international stocks.

It is because different asset classes usually give varying responses to changes in the market and economic conditions.

For example, a domestic event that causes the U.S. stock prices to decline may lead to an increase in domestic bond prices.

Moreover, even if different asset classes lead to a decline, the magnitude of decline would vary i.e., while one asset class may experience a downfall of 15%, the other might decline by 5% only.

The table given below shows that while major asset classes have delivered negative returns almost 25 to 40% times during the 120 calendar quarters over the last 3 decades, it also shows that only 3 of the last 120 calendar quarters have seen them all declining in the same quarter.

It shows that a huge diversification across multiple asset classes can drastically lower the possibility of a portfolio undergoing dramatic declines. Therefore, adding multiple longer-term asset classes to their portfolio is essential for investors with long-term goals.