Slicing Up the Stock and Bond Pies

Step 1: Can My Portfolio Allocation Reduce Risk Without Lowering My Return?

Once you have decided on your portfolio allocation among the three major asset categories—stocks, bonds and cash—your most important work is over. Yet, your portfolio at this point is only broadly sketched. It is now time to rough in a few details.

To review the major risks facing the three asset categories:

• Business and industry risk
  is high for both stocks and bonds, but can be eliminated by diversifying among different stocks with different industry groups.
• Inflation risk
  for bonds is high, but can be reduced by including stocks in the overall portfolio;
• Liquidity risk
  is high for stocks and bonds, but within an investor's portfolio it can be reduced by including cash (money market and short-term certificates of deposit).

That leaves stock market and interest rate risk as the major risks facing investors. Stock market risk is due to the volatility of the overall market, which can cause even attractive stocks to drop in price. Interest rate risk is due to the sensitivity of bond prices to changes in interest rates—rising interest rates cause existing bonds to drop in value.

At this stage in the allocation process, the goal is to try either to reduce those risks without substantially affecting overall return, or to enhance return without substantially adding to those risks—or both.

The best approach to reducing stock market and interest rate risks is to find segments within the stock and bond markets that are affected by different kinds of factors. While one segment of the market may be down, the other segment may be less affected, providing higher returns over that period. As we shall see, some of these market segments are much more volatile than the others, but offer a higher return potential. The least volatile segment should be used as the core, with the other segments added to varying degrees depending on your tolerance for risk.

The overall affect of combining these segments is to smooth return variations—and less variation means less risk—without reducing return.

The data used to illustrate these market segments is based on average returns for mutual funds that tend to invest in each market segment. This data is the most meaningful source for comparing market segments for individual investors. However, it only covers a recent and limited time period. The year-by-year returns will provide you with some indication of how the market segments act relative to each other, but you should not assume that the absolute returns in each segment will recur.

Continue to Step 2 »