You’ve no doubt heard the proverb about avoiding a total loss: “Don’t put all your eggs in one basket.” If you drop one basket and the eggs break, you’ll still have intact eggs remaining in the other baskets. That’s pretty much the argument for applying this maxim to your investment portfolio (the mix of different investments you have in your 403(b) or other investment account).
The multiple baskets approach to investing is called asset allocation. The fancy terminology just means distributing or allocating your money among different asset classes. In addition to helping moderate downturns, the strategy offers additional benefits. There are three major asset classes, and each has its own distinct advantage. So, by owning all three, you can enjoy the benefits of each.
A Closer Look at Three Major Classes
Equities (stocks) have historically earned the highest returns over the long term. For example, over the 30 year period from 1979 through 2008, large company stocks returned an annualized average rate of 11%.* You may want to include stocks or stock funds in your 403(b) plan account for their long-term growth potential. However, this asset class has also shown more short-term volatility (or ups and downs in price) than the others. Because of this, in most cases, you should plan to hold equities for the long term in order to ride out the ups and downs.
Typically, a major part of the total return earned by equities comes from appreciation, or an increase in price. (Some stocks pay dividends, which provide a steady stream of income; but many do not.) So, in order to get money out of an equity investment, you may need to sell it.
Fixed-income investments (bonds) have historically earned lower returns but experienced less volatility than equities over the long term.* For the period 1979 through 2008, intermediate government bonds return an annualized average rate of 8.6%.* The lower volatility makes them more suitable for short-term, as well as long-term, holding periods. Also, much of the return normally comes in the form of interest payments. So, you can receive an ongoing stream of income without having to sell investments.
Cash equivalents, such as Treasury bills and money market funds, have experienced the lowest returns but also the lowest volatility of the three classes, over the long term. For the period 1979 through 2008, U.S. Treasury bills returned an annualized average rate of 5.8%.* This asset class’s advantage is liquidity – the ability to convert the investment into cash quickly and easily.
Marching to Different Drummers
Each of the asset classes responds in its own way to economic and market conditions. Equities and fixed-income investments, for instance, often tend to move in opposite directions, though this does not always happen.
When you divide your money among the asset classes, one portion of your portfolio may be doing well as another faces a downturn. Also called diversification, spreading your money among different investments can help moderate your portfolio's overall volatility.
* Source: 2009 Ibbotson "Stocks, Bonds, Bills, and Inflation (SBBI) Classic Yearbook, Morningstar, Inc. Large company stocks are represented by the return of the Standard & Poor's 500 Index. Individual investors cannot invest directly in an index. Past performance is not an indication of future results.