Net Gains: The Dow Is Jumpy but You Aren't
The Dow falls 4 percent in a week. Diversification lets you weather a storm.
Nov. 14, 2007 — -- You probably know the Dow Jones industrial average had a tough time last week, as it lost nearly 4 percent of its value. But did you know the Dow Jones moderate portfolio index scored a 2.3 percent gain for the week?
Consider that an instant lesson in the benefits of asset allocation. Spread out your investments among a variety of asset classes, and you will reduce risk and maybe even boost returns.
With either index, of course, a one-week period is far too short to draw any conclusions, but the performance difference last week illustrates the importance of avoiding a portfolio concentrated in one stock, one market segment or one asset class.
The Dow Jones industrial average represents a major slice of the U.S. stock market in the form of the large cap stocks, but it is highly concentrated with just 30 blue chips making up the index. It may be easy to track, but it is not representative of a typical portfolio.
The Dow Jones moderate portfolio index, while obscure, is an index meant to be a benchmark for a well-diversified mix of U.S. and international stocks -- large and small -- bonds and cash. The term moderate refers to moderate risk with a 60 percent stock allocation.
For many portfolios, the Dow Jones moderate portfolio may be a better barometer than its well-known cousin.
I bring this up not to suggest your own portfolio should mirror the DJMP, but to point out the benefits of diversification and asset allocation. If you allocate among a variety of investment types, you need not obsess about a 300-point market drop on any given day.
Instead, you build a portfolio for times like these. You construct it under the assumption there will be days when the stock market drops 2 percent, months when it falls 10 percent and years when it tumbles 20 percent.
But you also build it to capitalize on the days it climbs 3 percent, the months it rises 11 percent and the years when it leaps 21 percent.
Knowing this, you decide upon a mix of stocks, bonds and cash appropriate for you based on your investment time frame and your own stomach for risk. The higher your risk tolerance and the longer your time frame, the more you allocate to stocks; the lower your risk tolerance and the shorter your time frame, the more you allocate to bonds and cash.
Within those broad outlines, you decide how much to set aside for specific asset classes, such as U.S. small caps, international developed stocks, emerging markets investments and real estate.
Now let's step away from an index and take a look at how diversification works in practice through the performance of two mutual funds that offer sound diversification in one investment.
The Vanguard LifeStrategy Moderate Growth Fund offers a 65 percent allocation in stocks and a 35 percent allocation in bonds and cash through investments in four Vanguard index funds representing both the U.S. and international stock and bond markets.
Last week, this fund posted a 2.4 percent decline. Not great, but better than the 4 percent drop in the Dow. Also, its five-year average annual return of 11.8 percent is slightly better than the Dow's over the same period, even though it means less investment risk.
The second fund to consider, the Fidelity Four-in-One Index Fund, invests in four Fidelity index funds, as its name suggests. With its 85 percent allocation to U.S. and international stocks, it is more aggressive than the Vanguard fund considered above. As a result, its performance last week was somewhat worse -- down almost 3 percent -- but still better than the Dow's 4 percent drop.
As with the Vanguard fund, the Fidelity Four-in-One Fund's performance last week demonstrates that diversification can't guarantee there will be no loss during a down market, but it can help cushion the blow.
But again, taking a longer look back shows the Fidelity Four-in-One's three-year average annual return was nearly 2 percentage points better, even though its risk level was lower than the Dow.
That's asset allocation at work. Lower risk, higher returns over the long haul.
Keep that in mind the next time the Dow drops 300 points in a day, and you're wondering what to do.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
Related Stories
ABC News Live