Asset allocation funds are designed to attempt to reduce volatility by spreading assets around to several different types of investments, including a variety of equity securities, bonds and other fixed income securities.
Although diversification – with several asset groups feeding into the performance of the portfolio – does not eliminate risk, it may help reduce losses during stock market fluctuations. For instance, when the prices of small cap stocks are falling, U.S. blue chip stocks or international stocks within the portfolio may be moving up, along with bonds and other debt-related assets.
It is important to note that bonds can also be volatile, particularly in times when credit quality comes under pressure or when interest rates are changing. However, over longer terms, bonds have historically had lower volatility than stocks. The two asset classes can often be correlated in the opposite direction (when stocks go down, many bond sectors tend to rise), so while multi-asset portfolios could have lower returns over the long term than an all-equity index like the S&P 500®, a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks, they will usually have lower volatility, too, often resulting in a smoother ride for investors.
The chart below shows the returns and standard deviation of returns (volatility) over a recent period for five different Morningstar Target Risk Indexes that represent various levels of diversification (with a mix of assets that may include stocks, bonds and other types of investments). The baseline is represented by the S&P 500, which shows an annualized return of 6.42% and a standard deviation of 15.00%. All five indexes had lower standard deviations than the S&P 500. All five had better returns per unit of risk than the S&P 500 as well.