Key Takeaways
- The key ingredients for a portfolio would be some kind of equity exposure, some type of fixed-income exposure, and some basic cash investments.
- What we’ve seen from real estate equities is kind of a steady upward march in correlations with the broad US equity market over the past couple of decades, to the point where I really don’t see the diversification benefit.
- When we look at investor timing, the cash flows in and out of sector funds is not a pretty picture.
- With thematic funds, oftentimes the themes are very much duplicated when we look at the broad market and are made after a good performance run.
- Investors could be getting a lot more volatility on an ongoing basis with a long-term bond portfolio.
- From a correlation and diversification standpoint, investors don’t need to go out of their way to add junk bonds or high-yield bonds to their portfolios.
Margaret Giles: Hi, I’m Margaret Giles of Morningstar. Building a successful investment portfolio can be as much about what you don’t add as what you do. Joining me to discuss five investment types that most investors can do without is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning. Christine, thanks for being here.
Christine Benz: Margaret, great to see you.
Investments Everyone Should Have in Their Portfolio
Giles: So before we get into what to skip, what are the essential ingredients that every investor should have in their portfolio?
Benz: Right. I’ve got these minimalist portfolios for retirees and people who are still working. The key ingredients would be some kind of equity exposure. I like broad market equity exposure, both US and perhaps more controversially non-US. I would say that’s an essential ingredient for people at all life stages, just that core equity exposure. And then from there, you might think about some type of fixed-income exposure, and that gets more essential as you move past age 50. I think adding in some stabilizer to the equity portfolio makes a lot of sense. You have an investment type with, yes, return potential that might not be that great, but much lower volatility than you have with equities. And then finally, just some basic cash investments that you need to meet your emergency expenses. Or if you are someone who is in retirement drawdown, I like the idea of holding a couple of portfolio withdrawals in cash on an ongoing basis to help protect you against a market like 2022 when both stocks and bonds fell at the same time.
Why Real Estate Doesn’t Have a Good Diversification Benefit
Giles: So stepping away from those core building blocks and moving over to the ones that investors can maybe skip, you think that real estate equities are a category that investors can just leave on the cutting-room floor. Why is that?
Benz: Yeah, we do this Diversification Landscape report where we look at correlations among major asset classes. And I’ve been on the sector fund beat for the past several years. And I’ve been looking at real estate. I remember earlier in my career, it was sort of like a must-have for portfolios. But what we’ve seen from real estate equities is kind of a steady upward march in correlations with the broad US equity market over the past couple of decades, to the point where I really don’t see the diversification benefit.
You might hold real estate because of their dividend yields or because they get cheap at various points in time. But from a correlation standpoint, I don’t see a great case for carving out an ongoing allocation to real estate. And another point I would make, Margaret, is that many people have some real estate in their total household financial capital. They have home equity. And so while real estate equities are different, they’re not necessarily going to behave exactly as your home equity will. It probably will move in sympathy. And so that’s another reason I think most investors don’t need to go overboard with real estate equities.
Why Investors Don’t Need Sector Funds
Giles: Right. So you mentioned you’re on the sector beat. You’re also not very keen on some of those other sector funds. Why not?
Benz: Yeah. One of the reasons is that when we look at investor timing, the cash flows in and out of sector funds, not a pretty picture, that investors often glom on to them after the sector has always already had a really good performance run. And then from a correlation standpoint, yes, we see correlations for certain categories looking pretty low relative to the broad equity market at various points in time.
So right now, for example, energy has been the correlations champ. But what I see when I look at the data is that those low correlations tend to be pretty ephemeral, that a correlation that looked low when we look back over the past three or five years might change around and might go back to being closely correlated with a broad US equity market. So I just don’t think you can take any one sector’s low correlations with the market to the bank in terms of constructing a portfolio.
How Investors May Be Duplicating Their Exposure With Thematic Funds
Giles: And in a related vein, you think investors can also easily skip thematic investments. So why is that?
Benz: Yeah, I’ve been keeping an eye on our team’s work on various thematic ETFs. And one thing we see is that, as with sector funds, a lot of the launches tend to occur after a theme has already had a good performance run. It’s good for asset managers to sell those products, but it’s not necessarily good for investors to buy into them.
And then another thing I see when I look at the thematic fund universe is that oftentimes the themes are very much duplicated when we look at the broad market. So for example, think of AI—right now, that seems like the can’t-miss theme that you need to have in your portfolio. Well, guess what? If you have a broad US equity market index, you’ve got plenty of exposure to the AI theme right there. So oftentimes, I think investors are doubling down on some exposures that they’re already heavily weighted toward.
Why Long-Term Bonds Could Lead to More Volatility in Your Portfolio
Giles: Right, and perhaps missing the timing on them as well. Exactly. For sure. So let’s move over to bonds for a little bit. There are a few categories that you think investors can really do without. Let’s start with one that maybe might not seem as obvious, and that is long-term bonds. So what’s the major drawback there?
Benz: Yeah, so with the correlations, it’s a little bit of a mixed picture. In a recessionary environment, a repeat of the great financial crisis, for example, long bonds performed really well during that environment. But there are other periods when stocks have gone down when long bonds haven’t looked so great. So 2022 was a great example of that. So they’re not foolproof diversifiers for equities. And then when we look at performance, what we see is a performance pattern that tends to be equitylike in terms of its volatility.
So I took a quick peek, Margaret, at kind of a US long-term Treasury index. The standard deviation over the past three years has been 15 versus a standard deviation of 6 for a core bond, like a total bond market index. So you’re getting a lot more volatility on an ongoing basis with that long-term bond portfolio. I think you can get yourself some good diversifying characteristics by just holding a core fixed-income portfolio, I don’t think you necessarily need to go out of your way to be adding long-term bond exposure.
Why Investors Don’t Always Need High-Yield Bonds
Giles: That makes a lot of sense. So lastly, high yield is another category in the bond area that you think investors can really skip. So most retirees like income. What are the disadvantages?
Benz: Yeah. And I wouldn’t rule out the idea of holding a little bit of high-yield bonds around the margins of my portfolio. Again, coming back to that diversification landscape paper, high-yield bonds don’t look great relative to equities as a diversifier. So a high-quality fixed-income portfolio, a total bond market index looks like a great diversifier, but high-yield bonds tend to be pretty well correlated to the equity market. When stocks are down, high-yield bonds are often down for the same reasons. So I wouldn’t necessarily think that, from a correlation and diversification standpoint, think that investors need to go out of their way to add junk bonds or high-yield bonds to their portfolios.
Giles: All right. So five different areas to consider avoiding. Christine, thanks for the time.
Benz: Thank you so much, Margaret.
Giles: I’m Margaret Giles with Morningstar. Thanks for watching.
Watch What Interest Rate Cuts Mean for Your Retirement Portfolio for more from Christine Benz and Margaret Giles.
