Why Diversification Matters

July 23, 2019
Over the past 30 years, stocks posted an average annual return of 10.4%, and bonds 6.8%. But actual returns varied widely from year to year.

When people think about investing for the long run, they often look to average market returns. For example, the broad U.S. stock market delivered a 10.0% average annual return over the past 30 years through the end of 2018, while the average annual return for bonds was 6.1%. However, stocks rarely delivered the average return in any given year—in fact, they did so only twice since 1989. Instead, as shown in the chart below, stock market returns swung widely, from up nearly 40% to down nearly 40%.

Figure 1: Annual stock and bond returns were rarely "average" over the past 30 years

Bar chart comparing annual returns of the S&P 500 Index and the Barclays U.S. Aggregate Bond Index with their 30-year averages showing that annual stock and bond returns were rarely average from 1989 to 2017.

Source: Morningstar Direct, 1/1/1989 – 12/31/2018.

Indexes used are: stocks, S&P 500® Index; bonds, Bloomberg Barclays U.S. Aggregate Bond Index. Indexes are unmanaged and cannot be invested in directly. Past performance does not guarantee future results.

By contrast, bonds generated close to their average return about five times over the 30-year period, and showed much less variance from year to year—returns ranged from a gain of approximately 18% to a decline of about 3%. Additionally, bonds were up when stocks were down, and vice versa.

Given their different characteristics, including a mix of stocks and bonds, with the amount of each determined by your risk tolerance, can help to diversify a portfolio and potentially generate a smoother pattern of returns over time.

The right mix may include many asset classes

U.S. stocks and bonds aren't the only potential ingredients in the recipe. Other asset classes, such as international stocks, real estate investment trusts (REITs), gold and other precious metals, and cash each have their own unique characteristics that can help diversify a portfolio. Of course, they each come with different investing risks, as well.

As shown in the chart below, a hypothetical portfolio that held a mix of U.S. and international stocks, bonds, commodities and cash delivered strong growth over time, but with less volatility than stocks alone.

Figure 2: Diversified portfolio delivered smoother performance over time

Source: Morningstar Direct, 1/1/1999 – 12/31/2018.

Indexes used are U.S. large cap stocks, S&P 500® Index; U.S. small cap stocks, Russell 2000® Index; international stocks, MSCI EAFE Index; core bonds, Bloomberg Barclays U.S. Aggregate Bond Index. The diversified portfolio was rebalanced annually and consists of 25% U.S. large cap stocks, S&P 500 Index; 10% U.S. small cap stocks, Russell 2000 Index; 20% international stocks, MSCI EAFE Index; 24% core bonds, Bloomberg Barclays U.S. Aggregate Bond Index; 8% high-yield bonds, Bloomberg Barclays U.S. Corporate High Yield Index; 5% gold and other precious metals, S&P GSCI Precious metals Index; 8% cash, IA SBBI US 30-Day Treasury Bill Index. Not representative of any specific investment or account. Indexes are unmanaged and cannot be invested in directly. Past performance does not guarantee future results.

Stay diversified: Don't try to chase short-term performance

Short-term performance across asset classes can vary significantly from year to year. It can be tempting to look at the best-performing asset class in any given year and question why you're invested in asset classes that haven't performed as well recently. But leadership across asset classes tends to vary from year to year, so generally a better strategy is to diversify across a mix of stocks, bonds, commodities and cash to benefit from exposure to whichever asset classes are performing well at any given time, while also helping to dampen the volatility of your overall portfolio.

How Schwab Intelligent Portfolios® can help

Given the broad range of asset classes to choose from, it can be a challenge to understand which ones and how much of each to invest in based on your goals, time-horizon and risk tolerance. Schwab Intelligent Portfolios is designed to automate this process for you. It builds a diversified portfolio of exchange-traded funds (ETFs) for you based on your current risk profile and automatically monitors your portfolio going forward, rebalancing as needed to help you stay on track toward reaching your goals.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Investing involves risks, including possible loss of principal.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Diversification, automatic investing, and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochures for important information, pricing, and disclosures related to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs.

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