Asset allocation, instead of asset concentration, can help diversify your portfolio and ensure that you’re always invested in the best funds.
The largest S&P 500 components have led the way in the past year’s rally, but does that mean you should ignore asset allocation in favor of going all-in?
Apple (AAPL) is up 36.88% over the past year. Microsoft (MSFT) gained 49.4%, while Amazon (AMZN) advanced 13.71%.
It’s true that these stocks contributed to the outperformance of U.S. markets, relative to global indexes.
But should you be focused on owning just the big names driving broad market performance? After all, plenty of lesser known and smaller companies had even bigger one-year returns, although they don’t have the size to propel broad markets higher.
Most investors initially approach the market with the idea of grabbing the highest return possible. That sounds like a good plan, doesn’t it? Who wouldn’t want to see their return grow by double digits, triple digits or more?
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But trying to load up on famous, “winning stocks” ignores a key component of any sound investment strategy: Risk management.
Managing portfolio risk essentially means smoothing your returns using different asset classes. Traditional asset allocation means including different types of investments in your portfolio. Large caps, small caps, domestic stocks, non-U.S. developed and emerging-market stocks all have a role.
Don’t Overlook Small Caps
A key tenet of the efficient markets hypothesis is small-cap outperformance. During certain periods of time, small caps notch better gains than the larger and better-known S&P 500.
According to research from the CME Group, the world’s largest derivatives exchange, there were three periods since 1979 when small caps outperformed.
- January 1979 – July 1983: The Russell 2000 small-cap index outperformed the S&P 500 by 77%.
- November 1990 – March 1994: The Russell 2000 outperformed the S&P 500 by 50%
- March 1999 – March 2011: Small caps outperformed large caps by 116%
During these periods, the U.S. was experiencing economic weakness. The CME Group noted that large caps tend to outperform during the later stages of economic expansion.
Now, has that been true recently? Let’s look at performance of domestic large growth vs. the broad asset class of domestic small caps over recent time frames, using a pair of Vanguard ETFs as proxies for their indexes.
- Over the past three years, the Vanguard Small-Cap ETF (VB) delivered a total return of 14.75%, while the Vanguard Growth ETF (VUG) returned 25.36%.
- On a one-year basis, the small-cap ETF returned 56.67%, while the large-cap fund returned 42.85%.
- Year-to-date, the small-cap EFT is up 16.31%, with the large-cap ETF returning 13.53%.
So, what should you, as an investor, make of those data points? Most investors simply don’t have the time, the skills or the inclination to develop a data-driven plan for tactical asset allocation.
In other words, you probably don’t want to spend your free time doing quantitative analysis on asset-class performance.
Fortunately, you don’t have to. While there’s certainly debate among financial advisors and institutional investors about tactical asset allocation vs. strategic allocation, as to which can eke out the better performance over time, an individual investor is generally best served by choosing a philosophy and sticking to it.
Why Asset Allocation Matters
As noted above, there are numerous asset classes besides domestic large cap. I’ll address foreign stocks and fixed income in a subsequent article, so we can focus on small caps today.
As we saw in our quick comparison of the Vanguard large-cap growth fund vs. the small-cap fund, asset classes perform differently over time. That’s precisely the reason why so many institutional investors, asset managers and financial advisors gravitate toward broad asset-class allocation rather than market timing. It’s extremely difficult to consistently know when a given asset class will lead or lag.
Of course, broad diversification means you won’t only own the top performers at any given time, but trying to snag the “best” return is an impossible feat.
For example, the best-performing U.S.-listed stock in 2020 was China-based Bit Digital (BTBT), a bitcoin mining company with a market cap of $749 million. Its 2020 return was 3,691%, ending the year at $21.91.
Did you go all-in on Bit Digital on January 2, 2020? Then hold your position for the entire year?
Didn’t think so. (Side note: The company has a problematic history, and the stock crashed in late 2019 on allegations of fraud. Even more reason to avoid it.)
But that admittedly absurd illustration shows you the folly of trying to snag the top return possible at any point.
Asset Allocation Spreads the Risk
Asset allocation increases the likelihood that you hold top performers during any given timeframe. Yes, it also means you’ll hold some laggards.
But the return you need shouldn’t be determined by some arbitrary measure such as “beating the market,” or doing better than your brother-in-law. It should be based on your time horizon, financial goals, lifestyle and spending, and other factors unique to you.
Here’s an encouraging thing about that kind of planning: It means you don’t have to constantly obsess about owning the top performer in your retirement portfolio.
By spreading the risk, you have a greater probability of achieving the return you need, rather than gambling and shooting for the stars with every investment.
What risk-management techniques do you employ to protect your profits and smooth out your returns?