Want to impress your friends? Here is a stock market prediction you can make at any time and almost always be proven right: The market will take a dive.
Market downturns are inevitable. Analysts and experts rarely argue if the market will drop and instead attempt to predict when it will drop. However, this harsh truth doesn't mean you need to suffer. Rather than resign yourself to the whims of the market, investors can take one simple step to help safeguard their assets during the next market downturn.
Why owning stocks isn't enough
While most investors are familiar with diversification, many don't take the concept far enough when constructing their portfolio. Spreading your money across numerous stocks makes intuitive sense from the perspective of risk. However, this approach still leaves you exposed to a host of risks impacting the broader equity market. For example, between April. 1, 2001 and Sept. 30, 2009, the S&P 500 fell by 43.75%. One would think that exposure to 500 companies would protect against losing nearly half of a portfolio. At the same time, small-cap U.S. equities plummeted by 30.48%, and developed foreign equities sank by 46.70%. What do these holdings have in common (other than disaster)? They're all equities.
The numbers underscore an important point; broad market downturns can devastate stocks across all sectors. Any investor forgetting this lesson would get a harsh reminder during the global financial crisis in 2008 when the S&P 500 fell even further losing 50.17%. Ouch.
How to diversify more
What's the answer? Asset allocation -- the practice of dividing one's investment across equities, fixed-income, and cash. A crude example of this strategy is the "60/40 Rule." The idea is simple: Invest 60% of your holdings in stocks and the other 40% in bonds. For example, a 60/40 investor might hold 60% of their investment in large-cap U.S. stocks and 40% in U.S. investment-grade bonds. With the investment spread across two asset classes, the investors have successfully diversified, right? Wrong.
The performance of this allocation falls short of many other portfolios that capture a wider collection of assets. One study, covering the period ranging from 1999 to 2013 found that the 60/40 composition returned less than portfolios which included more diverse investments like REITs, high-yield bonds, and emerging market stocks. The higher performing portfolios were more diversified encompassing a greater array of asset classes. They included small-cap stocks, short-term bonds, mid-cap stocks and more. In fact, researchers found that the hypothetical portfolio with the broadest asset allocation outperformed all others in the research.
Diversification isn't what it used to be
So, why doesn't an investment strategy spanning a few hundred stocks offer true diversification? The answer lies in a recent study from BlackRock. Researchers learned that the correlation, or the degree to which stocks move in tandem, increased between U.S. stocks and international stocks from 1980 to 2009. In fact, correlations more than doubled. Simply put: If one stock goes down, another stock is now more likely to do the same.
Diversification remains critical for investors in today's market because the recent gains in the stock market come at a time when the broad attitude toward risk appears cavalier. Valuations are running at near-record highs. For example the VIX (sometimes referred to as the "fear index") sank to the second-lowest quarterly average on record in the first quarter of 2017. This figure means investors perceive the market to be a very safe place.
However, because valuations are soaring, investors are paying high prices for stocks. If companies fail to deliver on these high expectations, we could be looking at a major drop in the market. One of the most effective ways to combat this risk is with a deeper diversification strategy that includes a mix of not only stocks but also other assets.
Ben Taylor has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.