How To Cushion The Stock Market’s Plunge

Amid the current virus-related stock market slump, the diversification concept is more precious than ever. You know the old adage: Don’t put all your eggs in one basket. Because if you trip, they all get smashed.

Spreading your wealth over as many types of investments as possible makes sense, but it requires some work. Unfortunately, messing up the asset allocation as you pursue a good diversification is all too easy.

Let’s look closely at stocks, which are the engine of a portfolio, as they go up most of the time. Many think that a great way to broaden their asset allocation is to fill out the stock requirement by putting money into a fund tracking the Standard & Poor’s 500, which is often called the “broad market index.” Well, up to a point.

The truth is, holding the index’s 500 stocks doesn’t give you a diversified portfolio. That’s because you get only one asset sub-class—large-cap U.S. stocks. In other words, those whose total stock value is worth more than $10 billion.

Back in 2008, the epicenter of the financial crisis, the S&P 500 fell 38%. If more of your holdings were in bonds, particularly U.S. Treasurys, the fall would not have been as bad. The Bloomberg Barclays U.S. Aggregate Bond Index, representing Treasury, corporate and other investment grade bonds, rose almost 6% in 2008, as people scrambled for safety.

This week, the Dow Jones Industrial Average, the Nasdaq Composite and the S&P 500 have entered into correction territory (a 10% fall from their highs). Yet the Barclays Bloomberg Agg is still up 3% for the year, which helps counter some of the pain of the stock loss.  

But how you populate the stock component of your portfolio is very important. Tech stocks compose a big chunk of the S&P 500 (almost 25%), which was not good news in 2000 to 2002, when the dot-com bubble popped. Until recently, the top tech stocks, such as Microsoft and Apple, powered much of the stock sector’s gains. Odds are that, once the virus panic eases, they will again romp. But they are in sorry shape of late. A better idea is to have a wider array of stocks, from categories like utilities, consumer staples and health care, which are less susceptible to bear market damage. And yes, you can buy them individually.

Beyond that, it pays to invest in actively managed mutual funds. Indeed, most of them fail to beat the S&P 500. Year in, year out, some 85% of stocks, whether large-, mid- or small-caps, don’t do better than the vaunted index. The obvious question: Why not find the 15% that have decent records exceeding the S&P?

In that spirit, check out Vanguard Dividend Growth: Over the past one and five years, this active fund outpaced the S&P by 2.1 and 0.2 (annualized) percentage points, respectively.

The $43 billion active fund has a mere 0.22% yearly fee, which is very low. Dividend paying stocks, which compose its portfolio, tend to be stable, with stalwarts like Nike and UnitedHealth. Solid dividends help bolster its returns. A recent acid test is how the fund did in 2018, when the S&P slid 19.9%, barely missing the 20% bear market mark. Well, the Vanguard fund gained 0.18%, hardly a blowout, yet a lot better than the benchmark stock index.

Certainly, keeping a basket of market-beating stock funds makes sense only as long as they actually keep surpassing the market. Example: Forester Value, which gained renown after the 2008 market wipe-out by being the sole active fund that didn’t lose money.

Thanks to a large cash position and investments in recession-proof holdings like Wal-Mart Stores and McDonald’s, it logged a 0.4% return for that horrible year, when the S&P dropped more than 30%. And now? The Forester fund fell 4.3% over the past year and 2.2% annually over three.

In the 1930s, investments pretty much were a choice of two: stocks or bonds. This balanced model was like a meat and potatoes diet—just two asset classes. Nowadays, we can construct much more diversified portfolios: meat and potatoes, plus vegetables, salad and dessert.

The most common form of a diversified portfolio–the meat-and-potatoes strategy–is the 60-40 stock-bond split. Lots of funds, sold by major providers like Fidelity, T. Rowe Price and Vanguard, have this breakdown. These are called “balanced funds,” although a real balance a 50-50 breakdown. The reason stocks get the bigger weighting is that they do better than bonds historically.

That said, however, putting so much into stocks, particularly American stocks, is shortsighted when so many alternatives exist. Take emerging market stocks, which are badly hit this year but have great prospects long-term. Commodities, like copper or cotton, should occupy 10% or so of your holdings. These are the epitome of diversification: Commodities tend to zig when stocks zag.

The goal is to have your winners offset your losers. And that’s why your assets should be in many baskets.

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