Navigating volatile markets is never easy, especially with so many “headline risks” right now.  

Fortunately, you can take some simple steps to help minimize the impact of volatility on your portfolio. One key step is to make sure your investment portfolio has the proper asset allocation.

Just two weeks ago, the S&P 500 ended a depressing third quarter down nearly 20 percent from its 2011 highs. Investor confidence sank with stocks knocking on the door of bear market territory.¹

Over the past 10 trading days, however, the S&P 500 staged an impressive reversal rally, up 12 percent from recent lows, leaving investors a bit dazed and confused by the market’s manic-depressive mood.²

Whipsaw moves like this have become commonplace this year. As you can see in the graph below, market volatility has been on the rise this year, spiking sharply higher in August and September.

And it’s no wonder why. So far in 2011, investors have witnessed natural disasters in Japan, political upheaval across the Middle East, a US government credit downgrade, slowing economic growth and a simmering debt crisis in Europe that threatens to boil over at any moment.

Given this backdrop, what’s remarkable is just how resilient stocks have been amid sour investor sentiment. After all, as of last Friday’s close, the Dow Jones Industrial Average was still posting a gain for 2011.

While the 2.6 percent total return for the Dow isn’t much to write home about, US stocks are performing far better than many other global equity markets as well as commodities. The MSCI World Index of stock markets excluding the US is down 11.4 percent year-to-date, for example, while fast-growing emerging market stocks are down nearly 17 percent.³

Bond markets, by contrast, continue to be among this year’s strongest performing asset classes. The Intermediate US Treasury Index, in spite of record-low yields, has gained over 5 percent, and the Aggregate Global Bond Index is up nearly 6 percent this year.⁴

This divergence in performance emphasizes the importance of maintaining proper asset allocation within your portfolio. It’s a good idea to periodically check your allocation to make certain it’s still aligned with your long-term financial goals and rebalance your portfolio if necessary. This is especially critical in turbulent markets.

Asset Class Diversification 101

Today, we use the term “asset allocation” rather than “diversification,” but it’s really a new term for a very old and time-tested investment concept. It’s a modern extension of the old adage that tells us not to put all of our eggs in one basket.

We all know that different asset classes (stocks, bonds, cash, etc.) tend to perform differently depending on the economic climate and where we are in the business cycle. But what you may not realize is that, generally, multiple asset class portfolios exhibit less overall volatility than the average volatility of each asset class individually.⁵

In other words, the risk-adjusted return of the whole portfolio is greater than the sum of its parts.

Leadership among asset classes tends to shift over time, sometimes very rapidly, in response to changes in financial markets and the economy. That’s why striking the right balance among the various asset classes can be critical in helping you ride out unexpected volatility.

Within a properly diversified portfolio some asset classes should perform well (such as bonds at present), while other assets lag (stocks and commodities). The idea is that your overall portfolio should experience far less up and down swings, even in turbulent markets, while still producing consistent total returns over the long haul if periodically rebalanced.

Perhaps the biggest benefit of proper asset class diversification then is that it eases the temptation of making emotionally-driven and often ill-timed moves with your portfolio in stressful markets.

A Basic Three Asset Class Portfolio

Proper asset allocation can be both an art and a science. Let’s take a closer look at the three most prominent asset classes of stocks, bonds and cash to see how they interact.

Stocks: It’s understandable why investors are worried about the stock market these days given the sharp volatility we’ve seen, not to mention all the headline risks at present. In spite of short-term volatility, however, equities have historically proven to be the best-performing asset class over the long run.  

Think of equities as an ownership interest in a business and a claim on its future profitability, not simply as letters scrolling across the CNBC ticker. Ideally, the benefit to owning stocks in your portfolio is realized over time, as dividend payments are collected (and reinvested) while earnings grow over the long term. Or as Warren Buffett is fond of saying, “My favorite holding period is forever.”

With markets volatile and stocks not showing much price appreciation this year, we prefer high-quality stocks with a long history of dividends in our core equity portfolios. In fact, high-yield dividend stocks have been among the best performers over the past three months.

The S&P 500's 2.2 percent dividend yield compares favorably to yields of less than 2 percent on 10-year US Treasuries recently. In our view, this offers a key support to stock valuations for investors with a long-term time horizon.

Bonds: Manic markets are tempting some investors to seek shelter in US Treasury bonds as a safe-haven that offers some protection from market storms.

The problem is that investors are paying a high price for that protection. Yields on 10-year Treasury bonds dropped to record lows of just 1.7 percent this month — down from a high of 3.5 percent in April. So we’ve already witnessed a big rally in bond prices, which move in the opposite direction of yield.

Still, fixed income asset classes offer important diversification benefits to your portfolio because they often exhibit a different pattern of returns than riskier asset classes like stocks and commodities.

At Banyan, we’re finding the best fixed income opportunities in higher yielding US corporate bonds where we can pick up yields over 5 percent with an average maturity of just over three years. Emerging market bond funds are another area we find attractive today. There are several well-diversified funds available yielding over 5 percent, compared with a 2 percent yield on 10-year US Treasuries.

Cash: Everyone knows that cash is trash these days, considering that 3-month T-bills yield practically zero interest. But cash is a viable asset class too, and it's a good idea to have some dry powder on hand, especially in volatile markets.

Holding some cash in reserve gives you the flexibility to be more opportunistic and buy other asset classes when they go on sale. Right now, keeping some cash on hand to deploy when conditions improve is probably a wise move.

Going Beyond Stocks, Bonds and Cash

One way to potentially reduce the volatility of your portfolio even more is to add alternative asset classes like commodities including gold, or real estate, which don't generally track markets for stocks and bonds. Commodities (especially gold) can also counteract inflation, because prices typically rise when inflation picks up and when the US dollar declines in value.

Commodities are a distinct asset class because the pattern of returns is most unlike any of the other major asset classes. For this reason, commodities can deliver the strongest diversification benefit when combined with stocks, bonds and cash.⁶

In today’s markets you’ve got to broaden your horizons to alternative and especially non-correlated asset classes. Differentiate your portfolio between international and domestic securities, both stocks and bonds.

For a truly diversified portfolio, consider adding alternative asset classes including commodities, global currencies, and real estate to your mix, as shown in the pie chart above. Above all, you’ve got to be nimble and proactive in shifting your asset allocation among these asset classes as market conditions change.

Bottom line: Investors understand that diversification can reduce volatility, but suspect that too much diversification can also water down returns. However, decades of research on asset class investing shows that proper diversification can enhance returns over long periods of time, not diminish them. The more dissimilar the asset classes you include within your portfolio, the stronger the diversification benefits can be when compared with investing your nest egg in just one basket.

Asset class diversification alone can’t assure you of gains in all market conditions, but can help minimize volatility in today’s turbulent markets. An active strategy using the right mix of asset classes can be a far superior approach, delivering not only less volatility, but the potential for greater expected returns in the long run.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Bloomberg market data, 10/19/11
² Ibid.
³ First Trust Market Watch, 10/17/11
⁴ Ibid.
⁵ Gibson: The Rewards of Multiple-Asset-Class Investing, 2006
⁶ Ibid.