As an investor it’s important to look at each of your holdings like a consultant and ask what it’s doing in your portfolio. Each investment should have a clearly identifiable role in the overall risk/return of your portfolio. This post covers some of the asset classes commonly used in portfolios to see what they might do to affect a portfolio's return potential.
US Stocks
I tend to think of large-cap US stocks as the first building block of an investment portfolio, so that’s where I’ll start. An investment in Vanguard 500 Index (VFINX) — a mutual fund designed to track the S&P 500 index, one of the more popular benchmarks for large-cap US stocks — would have earned an annualized return of 7.66% for the 10-year period ending June 30, 2014.
The next asset class we might consider adding to our portfolio is small-cap US stocks. Although they tend to be more volatile, stocks of smaller companies have historically outperformed large-cap stocks.
One of the more cost-effective ways to add small-cap stocks to your portfolio is to use a mutual fund that invests in the entire US stock market like Vanguard Total Stock Market (VTSMX) instead of using a separate small-cap stock fund. The average annual return of Vanguard Total Stock Market was 8.31% for the 10-year period ending June 30, 2014, which is 0.65% more per year than Vanguard 500 Index.
International Stocks
Although they’ve underperformed US stocks recently, as a long-term investor it’s a good idea to consider having international stocks in your portfolio. Not only could you benefit during times when international markets outperform the US market, but you could also benefit from international investments if the dollar declines against other currencies. For this asset class I’ll use DFA Large Cap International (DFALX) which invests in large-cap stocks in developed international countries.
Moving 50% of our portfolio to DFA Large Cap International and keeping the other 50% in Vanguard Total Stock Market for large- and small-cap US stock exposure would have earned 7.80% per year from June 2004 through June 2014. Although this mix produced a lower return than Vanguard Total Stock Market by itself, splitting your portfolio evenly between these two funds did produce better results than only holding an S&P 500 index fund over the same timeframe.
Emerging Market Stocks
Emerging markets like Brazil, India, and China don’t always move in lockstep with developed markets, so adding emerging market stocks could be a great way to diversify your portfolio. For this asset class I'll use DFA Emerging Markets (DFEMX).
A portfolio with one-third in Vanguard Total Stock Market, one-third in DFA Large Cap International, and one-third in DFA Emerging Markets would have averaged 9.45% per year through June 2014. This is 1.14% more per year than Vanguard Total Stock Market and a whopping 1.79% more per year than Vanguard 500 Index!
Real Estate Investment Trusts (REITs)
Many investors consider REITs to be an important addition to a portfolio. The historical return from REITs has been similar to large-cap US stocks, but REITs offer great diversification benefits since they don't move in tandem with the overall stock market.
Moving 25% of your investment assets to Vanguard REIT Index (VGSIX) — while holding 25% in US stocks, international stocks, and emerging market stocks — would have increased our theoretical 10-year average annual return to 9.76%. That’s quite a boost over a portfolio of only large-cap US stocks!
Value Investments
The last thing I’d like to do to our hypothetical portfolio is to add separate holdings for US and international small-cap value stocks. For domestic small-cap value stocks I’ll use DFA US Small Cap Value (DFSVX) and for international small-cap value stocks I'll use DFA International Small Cap Value (DISVX).
Just like small-cap stocks offer a higher return potential than large-cap stocks, value stocks have historically outperformed the market as a whole. But in order to capture the potentially higher returns from small-cap and value stocks, you have to be patient enough to hold them for the long-term. And this can be difficult to do when other segments of the market are outperforming value stocks.
So our final theoretical portfolio is evenly divided between Vanguard Total Stock Market Index, DFA Large Cap International, DFA Emerging Markets, Vanguard REIT Index, DFA US Small Cap Value, and DFA International Small Cap Value. This mix would have generated an average annualized return of 9.91% from June 2004 through June 2014, surpassing all of the other mixes we've discussed.
You can see that each of the mutual funds in this hypothetical portfolio serves a specific purpose. They each each represent a specific asset class — or a segment of the market with higher potential return in the case of DFA US Small Cap Value — and mixing them together is a way to have something that “zigs” when other holdings “zag.”
Don’t make the mistake of thinking that you’re diversified just because you have several different holdings. Take time to review each investment you have and ask, “What would you say you do here?”
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Investments mentioned in this post and throughout this blog are for educational purposes only and are not recommendations. Seek investment advice from your personal financial advisor before making any investments.
