Diversification: Your Best Retirement Planning Tool

The benefit of a diversified portfolio is that it helps protect you against having to sell investments at a loss during retirement. That’s a move that can severely harm your portfolio, especially in the early years. Proper diversification also “can literally double the money an investor can spend in retirement and double the amount that investor can leave to his or her heirs,” writes Paul A. Merriman, president of the Merriman Financial Education Foundation, in a MarketWatch column.

To reduce your risk of having to sell any holdings when they’re down, you’ll want to include a variety of asset classes in your retirement portfolio. Here’s a look at the major asset classes you might consider and their historic returns – as well as how to invest in them.

S&P 500 Stocks

From 1928 through 2015, the S&P 500 has returned a geometric average of 9.5% per year according to data compilations and calculations by finance professor Aswath Damodaran of New York University’s Stern School of Business.  (See What is the difference between arithmetic and geometric averages?) Virtually every investor will want to include this asset class in his or her portfolio, and the best way to do it is not to invest in individual stocks, which can be too risky, but to invest in a low-cost index fund or exchange-traded fund (ETF), which will give you broad exposure to hundreds of large, publicly traded U.S. companies.

Investment options for this asset class

  • Vanguard S&P 500 ETF (VOO): 0.05% expense ratio, 14.45% average annual return since the fund’s inception in 2010
  • iShares Core S&P 500 ETF (IVV): 0.07% expense ratio, 6.95% average annual returns over the past 10 years

Any fund that tracks the S&P 500 should perform similarly, so choose one with a low expense ratio. That way, fees won’t eat into your returns. (See The 4 Best S&P 500 Index Funds and How Can I Buy an S&P 500 Fund?)

Small Company Stocks

Small-cap blend stocks (consisting of 50% value stocks and 50% growth stocks) had annualized average returns of 12.7% from 1930 through 2013, according to data provided to MarketWatch by Dimensional Fund Advisors.Small-cap value stocks had annualized average returns of 14.4% over the same period.  By comparison, the S&P 500 returned 9.7% over the same period.  While small-cap stocks represent greater risk and volatility, they can pay off if you hold them long term and sell when they’re up.

Investment options for this asset class

  • Vanguard Small-Cap ETF (VB) (L4): 0.08% expense ratio, 6.82% average annual returns over the past 10 years
  • iShares Russell 2000 ETF (IWM) (L8): 0.20% expense ratio, 5.29% average annual returns over the past 10 years

(Read What are some of the best small cap index funds? and An Introduction to Small-Cap Stocks.)

Foreign Stocks

There are many ways to invest in a basket of foreign stocks. You could choose a country fund, a regional fund or a world fund. When diversification is your goal, investing in a single-country fund is akin to buying the stock of one company in the S&P 500 in that it’s considered higher risk.

A popular choice for getting exposure to lots of countries’ markets is through a fund that tracks the Morgan Stanley Capital Index Europe, Australia and Far East Index (MSCI EAFE). Its gross returns since May 1, 1994, are 4.95%.  Since 2002, its best year (2003) returned 39.17% and its worst year (2008) returned -43.06%.  

Investment options for this asset class

  • iShares MSCI EAFE Index ETF (EFA): 0.33% expense ratio, 1.71% average annual returns over the past 10 years 
  • Vanguard MSCI EAFE ETF (VEA): 0.09% expense ratio, –0.91% average annual returns since inception in 2007 

When choosing a foreign stock fund for your portfolio, make sure the fund either excludes U.S. companies or that you account for the fund’s U.S. holdings in your portfolio’s overall asset allocation. The MSCI EAFE index excludes U.S. companies and includes mid- and large-cap stocks of many companies in developed countries.  (For further reading, see EFA: iShares MSCI EAFE Index ETF, VEA: Vanguard MSCI EAFE ETF and Finding Fortune in Foreign Stock ETFs.)

Government Bonds

Bonds with longer terms usually pay higher interest rates than bonds with shorter terms, but since they have a higher risk of losing value to inflation, shorter-term bonds may be a safer bet. 

3-month T-bills – These short-term debt obligations, backed by the U.S. government, have returned 3.45% on average (geometric) per year between 1928 and 2015, according to Damodaran. 

Treasury inflation-protected securities – First issued in 1997, TIPS are bonds that are indexed for inflation. They have a fixed interest rate and a fixed maturity date, but their principal value increases or decreases each month in accordance with the inflation rate. This investment is good for preserving the value of your money, but not for increasing the real value of your portfolio. (See Retirement Planning: Why Real Rates of Return Matter Most.)

10-year U.S. Treasury bonds – From 1928 through 2015, these interest-paying federal government securities have returned a geometric average of 4.96% per year, according to Damodaran.  (Learn more in Why 10-Year U.S. Treasury Rates Matter.)

You can invest directly in U.S. government bonds through TreasuryDirect.gov to lock in your return and maturity date, but you’ll have to reinvest the semiannual coupon payments yourself.  You can also invest in government bonds through mutual funds and ETFs, where you’ll hold bonds with a range of maturities and the fund company will automatically reinvest the bonds’ distributions. It’s also easier to achieve diversification with a bond fund compared with purchasing individual bonds. (See Pros and Cons of Bond Funds vs. Bond ETFs.)

Investment options for this asset class

  • iShares TIPS Bond ETF (TIP): 0.20% expense ratio, 4.48% average annual returns for the past 10 years
  • iShares 1-3 Year Treasury Bond ETF (SHY): 0.15% expense ratio, 2.36% average annual returns for the past 10 years 
  • iShares 3-7 Year Treasury Bond ETF (IEI): 0.15% expense ratio, 4.60% average annual returns since 2007 
  • Vanguard Intermediate-Term Treasury Fund Investor Shares (VFITX): 0.20% expense ratio, 5.09% average annual returns for the past 10 years 
  • Vanguard Short-Term Treasury Fund Investor Shares (VFISX): 0.20% expense ratio, 2.72% average annual returns for the past 10 years 
  • Schwab Short-Term U.S. Treasury ETF (SCHO): 0.08% expense ratio, 0.72% average annual return since the fund’s inception in 2010
  • Schwab U.S. TIPS ETF (SCHP): 0.07% expense ratio, 3.22% average annual return since the fund’s inception in 2010 

Why Invest in Apparent Losers?

You’ve undoubtedly noticed that some of these asset classes have much better long-term returns than others. If S&P 500 returns are so much better then MSCI EAFE returns, for example, why invest in this basket of international stocks at all? And if small-cap stocks offer better returns than the S&P, why invest in the S&P?

The big issue with small-cap stocks is volatility and economic sensitivity, says chartered financial consultant Paul T. Murray, president of PTM Wealth Management in Chalfont, Pa. “It seems to be true that small caps offer higher long-term returns, but they can be absolutely demolished in recessions, or in major market declines like those of 2000 to 2002 and 2007 to 2009.”

These companies are more sensitive to economic downturns, Murray says, and in general, small-cap stocks offer a wild ride compared with the large companies of the S&P 500.

As for investing in the EAFE (Morgan Stanley's Europe, Australia and Far East Index, discussed above under Foreign Stocks), Murray says, sometimes you can do very well, and sometimes you aren’t at all compensated for the risk you take. But they may zig while the U.S. market zags, and thus may offer an overall smoother ride for investors.

The Bottom Line

Investing in different asset classes, especially through ETFs or mutual funds, can provide broad diversification, reduce your risk and improve your returns. Because U.S. stocks, small-cap stocks, international stocks and U.S. government bonds perform differently, including some of each in your portfolio gives you options for what to sell in any market.

Diversification can help you avoid selling investments at a loss – or mitigate your losses – which also helps to preserve your porfolio’s long-term value and keep your retirement plans on track. (For further reading on how to structure your retirement portfolio, see How Near-Retirees Can Ride Out Market Volatility and Protect Retirement Money from Market Volatility.)