It’s normal to want to know how your investments are doing. The question is, “compared to what?” The most common benchmark for U.S. stock market investors is the S&P 500 index, which most people refer to as the “market”. The S&P 500 index represents only one specific asset class which is domestic large companies. However, it is often inappropriately used as a benchmark for investors whose portfolios have very different risk characteristics.
For example, balanced portfolios include numerous other asset classes, each with different risk and return characteristics than the S&P 500 index. Therefore, the S&P 500 Index is a good benchmark for you ONLY if your portfolio contains domestic large company stocks and no other asset classes.
To answer the question of “compared to what?” we have to compare your portfolio to a benchmark that is made up of similar asset classes in the same proportion to your portfolio. It is important to keep in mind that the long-term performance of your portfolio as a whole is what matters.
It has been proven that investment return is far more dependent on investor behavior than on fund performance. Studies show that over 90 percent of investment returns are determined by how investors allocate their assets versus security selection, market timing and other factors.
Diversifying your portfolio makes you less dependent on the performance of any single asset class.
Effective diversification requires combining assets that behave differently when held during changing economic or market conditions. Moreover, investing in assets that have dissimilar return behavior may insulate your portfolio from major downswings.
This image illustrates the annual returns of three different portfolios over a 10-year time period. Stocks represent a 100% investment in large stocks. Bonds represent a 100% investment in long-term government bonds.
Notice that stock returns were up at times when bond returns were down, and vice versa. However, when the stock and bond asset classes were combined into an equally-weighted portfolio, the portfolio experienced less volatility than stocks or bonds alone. These offsetting movements assisted in reducing portfolio volatility (risk).
Normally, one would expect the 50/50 portfolio return to be between the stock and bond returns. However, since the portfolio was rebalanced every 12 months, it benefited from an unusual phenomenon called “the rebalancing bonus.” This “bonus” is sometimes gained because of a specific combination of risk and return for the two asset classes that make up the portfolio.
Diversification does not eliminate the risk of experiencing investment losses. Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than bonds.