Key Takeaways
- Essential elements of a portfolio include specific stock investments, certain fixed income assets, and some cash holdings.
- The performance of real estate equity hasn’t shown significant diversification benefits compared to the broader US stock market in recent decades.
- The pattern of cash flows into and out of sector funds is not particularly encouraging.
- Themes in investment tend to be replicated across various markets, often after they have shown strong performance.
- Investors might experience increased volatility with their long-term bond investments.
- From a diversification standpoint, there’s no need to include junk or high-yield bonds in a portfolio.
Margaret Giles: Hi, I’m Margaret Giles from Morningstar. Developing a successful investment portfolio involves knowing what to avoid just as much as what to include. I’m joined by Christine Benz, director of personal finance and retirement planning at Morningstar. Thanks for being here, Christine.
Christine Benz: Glad to be here, Margaret.
Investments to Include in Your Portfolio
Giles: Let’s start with what every investor should definitely consider having in their portfolio.
Benz: Absolutely. I recommend minimalist portfolios for both retirees and those still in the workforce. A key element is having some stock exposure. I favor broad market stock investments, including both US and, possibly, non-US options. This exposure is critical at any life stage. Then, it’s wise to think about adding fixed income as you age, especially after 50. These can act as stabilizers in an equity-heavy portfolio. Sure, some investment types don’t perform great, but they usually bring lower volatility compared to stocks. Plus, having basic cash investments is necessary for emergencies or ongoing portfolio withdrawals, which is especially relevant during tough market years like 2022 when both stocks and bonds were down.
The Limitations of Real Estate for Diversification
Giles: Shifting focus from core elements to areas like real estate stocks might not be beneficial for all investors. What’s your take on that?
Benz: We regularly conduct diversification landscape reports analyzing correlations among key asset classes. Real estate was once a must-have for portfolios early in my career, but now it seems to offer little in terms of diversification benefits relative to the broader US stock market over the years.
While real estate might attract investors for its dividend yields or price dips, there’s not a compelling case for maintaining a sizable, ongoing allocation. Many people actually hold real estate through home equity, adding to their overall financial exposure in that sector. Therefore, while stocks and real estate serve different purposes, they can often react similarly to market changes, which may suggest that real estate stocks aren’t as essential as once thought.
Rethinking Sector Funds
Giles: You’ve also touched on your reservations about sector funds. Can you elaborate on that?
Benz: Sure. One issue is the timing of investments. Cash flows into sector funds often come after these sectors have performed well, which can paint a misleading picture of their desirability. While we see some correlation among categories that diverge from the broader market at times, these discrepancies tend to be temporary. For instance, while energy sectors may have low correlations now, they could easily revert to being closely aligned with the overall market, so relying on them for diversification may not be wise.
Thematic Investment Overlap
Giles: When it comes to thematic investments, why might they be better skipped?
Benz: The data from our ETF analyses shows that many thematic funds tend to launch after notable performance, which benefits asset managers, but not necessarily investors. Moreover, many themes overlap significantly; take AI, for example. Those focusing on a wide array of US stock market indexes likely already have sufficient exposure to AI without needing a dedicated fund for it. This suggests many investors might inadvertently duplicate their exposures.
The Volatility of Long-Term Bonds
Giles: Now, let’s talk about bonds. Long-term bonds can really put investors in a tricky spot. What’s the downside here?
Benz: The correlation is complex. During recessions, long bonds can perform well, but in other scenarios, they can underperform. 2022 is a prime example where they didn’t provide the shelter one might expect. Thus, they aren’t foolproof diversifiers. I noticed that the volatility for long-term treasury bonds was significantly higher than that of core bonds, suggesting that holding a core fixed income portfolio might offer adequate diversification without adding long-term bonds.
The Case Against High-Yield Bonds
Giles: I see, so high-yield bonds are another area where investors might want to tread carefully. What do you think?
Benz: Yes, I don’t completely dismiss holding some high-yield bonds in small amounts, but I return to the correlation aspect. In terms of diversification, high-yield bonds don’t perform as well as a good-quality fixed income portfolio. They tend to move closely with stocks, meaning when equities decrease, high-yield bonds often do too. Therefore, from both correlation and diversification viewpoints, investors should be cautious about adding junk or high-yield bonds to their portfolios.
Giles: So, we’ve outlined a handful of areas to avoid. Thank you for your insights, Christine.
Benz: Thanks, Margaret.
Giles: I’m Margaret Giles from Morningstar. Thank you for watching.
For more information, see insights on what interest rate reductions might mean for retirement portfolios.
