Is your portfolio positioned to weather the next storm?

You've likely heard the adage "a rising tide lifts all boats." When applied to the stock market, it means that individual stocks tend to benefit when overall markets rise. But what happens when the tide retreats or storm clouds gather? According to John Canally, CFA, Chief Portfolio Strategist for TIAA's Investment Management Group, "that's when it becomes clear that those who are diversified are in a better position to weather whatever comes their way."

While none of us can predict how the markets will perform at any given time, there are steps you can take to address the challenges presented by the market's ups and downs. Preserving wealth in any market climate begins with diversification. But what exactly is diversification? And how much is enough? Below, we answer these questions and more to help you manage risk along the path to your important goals.

1. What is diversification?

One of the first principles most investors learn is 'don't put all your eggs in one basket. "While that speaks to the basic concept, according to Canally simply investing in several different funds or asset classes doesn't constitute a well-diversified portfolio."

That's because portfolio diversification takes a number of factors into consideration, including the correlation between markets, asset classes and investment types; whether holdings are actively or passively managed; and personal goals, risk tolerance and investment time frame, among other criteria.

For example, if you own an index fund that invests in a large number of U.S. stocks, you may enjoy a degree of diversification across U.S.-based companies. However, when U.S. stocks fall all at once, that provides little overall protection for your portfolio.

To effectively manage risk, your portfolio needs to be spread among a well-diversified mix of securities.

To effectively manage risk, your portfolio needs to be spread among a well-diversified mix of securities that may include stocks of small and large companies, U.S.-based and international equities, short- and long-term bonds, and both international and domestic bonds.

"Depending on your risk appetite and understanding of how different holdings may complement your portfolio, additional investment considerations may include the ownership of real estate and other alternative investments," Canally said. "However, diversification doesn't end there. We also want to look at how different investments and asset classes correlate to one another."

Correlation is a statistical measure that can be used to determine how individual securities (such as stocks), entire asset classes or broad markets move in relation to each another.

This is important because each asset class comes with its own investment risks and potential for growth or income, with most investments falling into one of five asset classes ranging from conservative to risky. For example, cash equivalents (including money market funds, U.S. Treasury bills and short-term certificates of deposit) are on the more conservative end of the spectrum, while equities (stocks) are on the riskier end. Generally falling somewhere in the middle are guaranteed investments (fixed-rate products backed by the claims-paying ability of the issuer), fixed-income investments (bonds and bond funds), and real estate. If you are heavily invested in stocks, you may have a greater potential for return, but you're also exposed to greater risks, such as investment losses, compared to more conservative fixed-income assets.

2. Diversification helps to preserve wealth, not maximize it

According to Canally, investors often incorrectly associate diversification with higher returns or assume that diversification helps to maximize their wealth. Rather, diversification helps to preserve wealth by delivering higher-quality returns versus explicitly higher returns.

The importance of diversification

It is difficult to predict which types of investments will do best in any given year.*

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
* Source: Data derived from Morningstar DirectSM, Morningstar, Inc., 2020. All data represents total returns for the stated period. Past performance does not guarantee future returns.
** Volatility is defined as standard deviation (2006-2020); the greater the volatility, the greater the variance to the mean return of a given asset. 60/40 Diversified Portfolio assumes annual rebalancing.

As the chart above illustrates, it's difficult to predict which types of investments will perform the best in any given year. The orange line across the chart represents the annual return of emerging market stocks, which is at the top during some years and at the bottom for others. As the chart illustrates, in years when emerging market equities were doing well, such as 2005 – 2007, other sectors, such as bonds, were struggling. But look at 2008, which marked the start of the Great Recession. Bonds were the top performing sector that year while emerging markets took last place. Fast forward a year to 2009, and they reverse places again, with emerging markets back on top.

The moral of the story? If you were solely invested in any single asset class over the past 15 years, you were in for a wild ride. That's why diversifying your investments across a wide variety of asset classes—as opposed to concentrating in just a few holdings—improves the likelihood that, on balance, you will have a positive overall return, or at least a less negative return.

"This relative stability is why, even when markets are down, a properly diversified portfolio can improve the likelihood of achieving your goals and provide a smoother ride along the way," Canally said. To achieve that end, it's critical to align your diversification strategy with your goals, the time frame for achieving them, and how much risk you're willing to take as an investor to accomplish them.

3. Quality over quantity

However, simply owning a lot of different assets is not enough. In addition to the number of securities you own, you want to determine if fund holdings overlap— resulting in double or triple ownership in the same investment types or asset classes, which can undermine your strategy. For example, you may think you're diversified if you own both exchange-traded funds (ETFs) and individual U.S. stocks in your portfolio; but if the ETF you own is made up of U.S. stocks, you're not diversified at all. You also want to make sure your money is spread geographically, across different countries and regions, as well as across different sectors, industries, currencies and types of debt.

"Ultimately, you want to ensure your assets are allocated in a way that reflects your personal tolerance for risk—so that you remain comfortable holding your investments during periods of market instability," Canally said. "If you're not comfortable riding out volatility, it's likely that you may have misjudged your tolerance for risk."

Hypothetical portfolio performance

1926 to 2019

This chart helps to illustrate this concept, showing how an appropriately diversified strategy can lessen the range of potential outcomes, with a higher degree of confidence, versus investing in a single asset class.

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. The information, data, analyses, and opinions contained herein do not constitute investment advice offered by Morningstar and are provided solely for informational purposes. ©Morningstar. All rights reserved.

The chart above helps to illustrate this concept, showing how an appropriately diversified strategy can lessen the range of potential outcomes, with a higher degree of confidence, versus investing in a single asset class. For very concentrated portfolios, and even more so for higher-risk asset classes, the range of outcomes is much greater.

For example, the hypothetical 100% stock portfolio on the far right would have produced returns ranging from 162.9% to -67.6% for the period 1926-2019. For the same period, a portfolio comprised of 60% bond and 40% stock holdings would have produced a much narrower range of returns, between 62.5% and -33.7%, over the same period. While investors in the more conservative 60%/40% portfolio would not have benefited from the extreme highs produced by the 100% stock portfolio, their downside exposure would have been roughly half that of the all-stock portfolio.

"We know that diversification is working when the things that were holding you back suddenly become the things that are holding you up," Canally added.

"…diversification is working when the things that were holding you back suddenly become the things that are holding you up."

4. Steps you can take now to weatherproof your portfolio

Staying on course toward your long-term goals can be especially challenging during periods of uncertainty, like we experienced in 2020. According to Canally, while it's nearly impossible to predict when the next market downturn or economic crisis may occur, we know that eventually one will. That makes it important to take steps now to ensure your portfolio is positioned to help you remain on track and ride out any storms that come your way.

Begin by reviewing your current asset allocation. That refers to how you have distributed your investment across different asset types, such as stocks, bonds and cash. Over time, market swings can throw your asset allocation—and potentially your risk targets and investment goals—out of balance. When this happens, you can rebalance by moving money from investments that take up a greater portion of your portfolio than desired into those that could use a boost—to get back to the initial (or target) asset allocation. While rebalancing doesn't protect against losses, it can help you stay on track to meet your goals.

"Reach out to your TIAA wealth advisor if you need help determining if and when your portfolio needs shoring up, so it remains aligned with your risk tolerance and long-term objectives," Canally said.

You also want to avoid drawing down on long-term assets when the market is in flux.

"These are assets you don't intend to use for 3 to 5 years or longer," Canally said. "Whether you are nearing or in retirement, it’s important to remember that you're still a long-term investor. You need your portfolio to continue generating income and growth throughout your time in retirement."

Remember that in a declining market, you still own the same number of shares. Even if the value of those shares have declined, the number of shares you own has not. As long as you remain invested, you preserve those shares and reduce potential losses, which is critical as the markets begin to recover.

Canally emphasizes that a well-defined, repeatable investment process focused on asset allocation and diversification can help you move forward with confidence in any market environment.

If you have questions about whether your portfolio is adequately diversified and allocated in a way that reflects your personal tolerance for risk, or if your risk parameters have changed, contact your TIAA wealth advisor to schedule time to talk about your concerns.