The first quarter of 2008 made the difference between well-designed portfolios and poorly designed portfolios obvious. Check your quarterly statement to see which category describes your portfolio.

You may hesitate to change your investment strategy even if you suspect performance is suboptimal. Perhaps you believe your current investment mix went down so much simply because of the markets and will go up when the markets rebound. But this assumption is faulty.

Systemic problems, not market volatility, explain why some portfolios performed extremely poorly in the first quarter. If your asset allocation was unbalanced, you took the brunt of the drop because you are invested primarily in U.S. large-cap stocks. An unbalanced portfolio will continue to be unbalanced and gyrate randomly rather than progressing steadily toward your goals.

Furthermore, if your underlying investments are laden with fees, they will continue to be even after the markets rebound. It may be difficult to see you are paying too much in hidden fees and expenses when the markets are going up. But when they go down, excess fees add insult to injury and exaggerate your losses.

We design portfolios using six asset classes, three for stability and three for appreciation. The three for stability are (1) short money (maturing in less than two years), (2) U.S. bonds and (3) foreign bonds.

1. Short money, such as cash, money market and CDs, continues to be the riskiest investment since 2002. Cash can be dangerous. When our currency decreases in value, we experience inflation and the purchasing power of our dollars is compromised. Having the same number of dollars doesn’t do you any good if they won’t buy as much as they used to.

The Federal Reserve lowered the rate of federal funds from 4.25% to 2.25% this quarter. It lowered the discount rate (the rate at which a limited number of institutions can borrow directly from the Fed) from 4.75% to 2.25%.

As a result, the dollar continued to slide in value, deteriorating several percentage points in the first quarter. The Euro rose about 3.4% against the dollar. The U.S. Dollar Index, measured against a broader basket of currencies, dropped about 5.3%. Even the Japanese yen rose over 8%. Finally, the price of gold went from $840 an ounce, past $1,000 and back down to $916, ending up over 9%.

This loss of the dollar’s purchasing power means that losses in all other categories were compounded. Not only did the U.S. stock market lose value in dollars, but the remaining dollars were worth even less. Three of the six asset classes protect you directly against a falling dollar, and more than half your portfolio should be in these investment classes.

2. The second asset class in stability is U.S. bonds. The Lehman Aggregate Bond Index was up 2.17% in the first quarter. Annualized, that would produce an 8.68% return. Treasury inflation-protected bonds provide some protection against a dropping dollar and appreciated 5.18% in the first quarter.

Having the right balance of stability to appreciation (fixed income to equities, or bonds to stocks) is important for a portfolio’s behavior.

Adding bonds to an all-stock portfolio can actually boost returns over the long term. When an all-stock portfolio performs poorly, you just have to wait for it to rebound. But when a portfolio is stable and the stock side bounces down, the natural process of rebalancing sells bonds at their high and adds to stocks at their low. This contrarian move helps the portfolio as a whole rebound more quickly by adding to the stock side when it is down.

Even in a very aggressive portfolio, bonds provide a stable store of value waiting for a market correction. This “dry powder,” or cash on the sidelines, can be invested into the markets after a drop to help your portfolio rebound quicker.

3. Foreign bonds, the third asset class in stability, protect you better against the weakening of the dollar. They did very well in developed countries, appreciating nearly 10%. But emerging market bonds were flat. A mix of mostly developed countries and a third in emerging market bonds would have produced a return of around 7%.

The three additional asset classes for appreciation are (4) U.S. stocks, (5) foreign stocks and (6) hard asset stocks. U.S. stocks did the worst.

4. The Dow was down 7.55%, the S&P 500 was down 9.44%, the Russell 2000 lost 9.90% and the NASDAQ lost 14.07%. The average daily volatility in the first quarter was 1.21% compared with a historical average of 0.75%.

Value stocks lost less than growth with small value doing the best, only losing 5.28%. Oddly enough, small growth did the worst, losing 14.40%. Small- and mid-cap stocks have soundly outperformed large cap over the past five years, so your portfolio should tilt toward small and value.

Technology stocks did the worst this quarter. The sectors that lost the least were consumer services and consumer goods.

So U.S. stocks were definitely down. But if your U.S. stock losses were approaching 10%, one of three things is probably wrong with your portfolio: You have all U.S. large cap stocks, you are overly invested in volatile funds or your excessive fees are dragging down your investments. You can view the expense ratio on every fund you own at www.morningstar.com .

5. Many foreign markets fared even worse. Emerging markets were down 11%. Britain’s FTSE was down 11%, France’s CAC was down 16.3%, and Germany’s DAX was down 19%. The EAFE foreign index, however, was only down 8.91%.

The 11 countries we recommend with the most economic freedom fared better than average, only losing 8.23% for the quarter. Overall, your foreign investments should have done slightly better than your U.S. investments. We believe foreign stocks provide better country diversification and also protect your investments against the devaluation of the dollar.

6. The third asset class for appreciation is hard asset stocks, which include companies that own and produce an underlying natural resource, such as oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel and other resources such as diamonds, coal, lumber and even water.

These stocks exhibit a unique set of characteristics: They have a low correlation with other stocks and bonds and they appreciate with inflation.

Gold and oil both hit record highs in March. They then fell 12% and 11%, respectively, in just three days. Crude ended the quarter up 5.9%, gold was up 10.3% and natural gas was up 30.9%. These commodity prices affect the long-term price of hard asset stocks. With the gyration in prices, hard asset stocks have been much more volatile than normal and lost 4.89% this quarter.

Asset allocation means always having something to complain about, but it also means always having something to be glad about. The S&P 500 was down nearly 10%, but a well-balanced portfolio should be down much less. Don’t assume that everything is down the same. Some portfolios just can’t overcome having all their assets in large-cap U.S. growth stock funds with excessive expenses. And because they are poorly designed, these portfolios won’t rebound as quickly with the markets.

Take the time to compute your first quarter’s returns and determine if your investments are designed to meet your goals. It’s an excellent opportunity to review your asset allocation and investment selection.

Photo by Vittorio Zamboni on Unsplash