A Diversified Portfolio: Sum of the Parts
Different types of investments perform differently from one another, which may make it possible to lower the risk of volatile assets
by combining them with other types of investments. Individually, each component in a portfolio has its own risk and return
characteristics and, in addition, these characteristics may change over time. Focusing on only one type of investment may leave
investors feeling a little uncomfortable because of volatility.
Since 1970, small stocks provided the largest returns, but also carried the highest risk. Bonds performed well with a lower risk than
stocks, and cash provided the lowest return with the least amount of risk. During the past 10 years (including part of the “lost
decade”), returns were lower because of the global credit crisis. The past five years were a period of recovery and therefore saw
much higher returns for stocks.
As the image illustrates, individual asset-class performance can fluctuate over time, particularly in shaky market environments, as
we’ve recently seen. With a diversified portfolio, at least, an investor may have a chance at navigating extreme market swings. For
all three time periods, the portfolio maintained a middle-of-the-road course, neither rewarding investors with top-performer returns,
nor punishing investors with worst-performer losses.
Diversification does not eliminate the risk of experiencing investment losses. Returns represent compound annual returns for the
time periods indicated. Risk is measured by annual standard deviation. Standard deviation measures the fluctuation of returns around
the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the
investment returns. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government
as to the timely payment of principal and interest, while returns and principal invested in stocks are not guaranteed. International
investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and
differences in accounting and financial standards. Furthermore, small stocks are more volatile than large stocks, are subject to
significant price fluctuations and business risks, and are thinly traded.
About the data
Small stocks are represented by the Ibbotson® Small Company Stock Index, large stocks by the Standard & Poor’s 500® Index,
which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general, and international
stocks by the Morgan Stanley Capital International Europe, Australasia, and Far East (EAFE®) Index. Bonds are represented by the
20-year U.S. government bond and cash by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index.
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