T. Rowe Price Study Shows Benefits of Diversification

Many investors frightened by two severe bear markets, a global financial crisis and the worst recession since the 1930s, have not yet fully gained confidence in stocks. But a new T. Rowe Price study, which makes the case for a diversified portfolio divided between stocks and bonds, may help calm investors' nerves.

The overall message, says Eduardo Ramos, of Freedom Advisory, in Guaynabo, Puerto Rico, is that “the bond ride is over and equities will bring back their shine.” Stocks have outperformed bonds in all 20- and 30-year periods since 1926, and more than 80% of the ten year stretches. And we’re emerging from a long bull market in bonds. As Jerome Clark, manager of T. Rowe Price’s Retirement Funds notes, the bull won’t last but bonds still work to reduce risk. “Bonds can help dampen the downside of equities, and equities can help increase the return potential of an all-bond portfolio over time,” he said. “That’s the real benefit of diversification.”

To prove the point, T. Rowe created hypothetical portfolios for a 35-year-old, 45-year-old and 55-year-old aiming to retire at 65, and looked backward at how they would have performed in all the 30-year, 20-year, and 10-year periods from 1950 through 2009. That period includes a wide range of scenarios, notably both the hyperinflation of the 1970s and the stock market bust of the past decade. By looking over many years, the study helps investors avoid conclusions based on recent experience. As Stuart Ritter, a T. Rowe Price financial planner, puts it, “Don’t look at one period and think it represents all of history and all of the future.”

Designed like target retirement funds, each portfolio's stock holdings decreased as the investor reached 65. The 35-year-old, with 30 years ahead, began with 90% stocks and 10% bonds. T. Rowe divided the 45-year-old’s portfolio between 78% stocks and 22% bonds, while the 55-year-old began with 67% stocks and 33% bonds. By age 65 each investor ended with a portfolio of 55% stocks and 45% bonds.

So how did our hypothetical investors do?

The 35-year-old: Thirty-somethings can take heart that the median annualized return for all 30-year periods was 10%. Even the worst 30-year period, ending in 1984, had an annualized return of 8.94%. Every period beat inflation, with a median annualized real return of over 5%.

The 45-year-old: With a 20-year time horizon, the results were almost as good: a median annualized return of 9.8%. The worst period, ending in 1981, still delivered a return of 6.35%.

The 55-year-old: The 10-year time horizon had the greatest volatility, but all periods produced positive returns. The return beat inflation in 80% of the 10-year periods. Also, maintaining stock exposure improved results more than 80% of the time compared with investing only in bonds.

To achieve results like these in real life an investor has to buy a target date fund and stomach downturns. Allan Roth, of Wealth Logic in Colorado Springs, Colorado, points out that studies like T. Rowe’s “assume that investors are logical rational beings, which we are not. Even fee-based planners panicked and sold at the market’s bottom.”

“It’s most important that we look at each client’s personal situation and see how much risk they need to take,” says Sheryl Clark, at Sunrise Financial in Tucson Arizona. “For a 65-year old who is completely retired, I would more likely have them in 40% stocks. Even with my clients in my mid-30s, I wouldn’t have more than 60% stocks. I wouldn’t subject them to that much volatility.”

Ramos agrees that for most retirees, 55% stocks would be too risky. Bonds are likely to become more volatile, but the best strategy he says is to “stay diversified.”

 

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