But Diversification Saves the Day
It is often said that investors like to drive by looking in the rearview mirror. This means that they are very captivated by what has happened in the market. They go so far as to lament what could have been, even if they would have considered an investment option ludicrous prior to gaining this attractive hindsight. And if investors go so far as to make investments based on what happened most recently, they are likely to construct portfolios that underperform and cost them substantial returns in the long run.
In reality, we are chartered with choosing an investment strategy in advance — one that will serve us through a variety of market conditions and personal financial needs. There are some investments that provide a great return in a short period and then provide a low return. There are some investments that consistently provide returns in the middle. And there are combinations of investments that are great because just as one is doing poorly, the other one is doing well.
Diversification: The Key to Forward-Looking Portfolio Choices
The key to achieving a fairly consistent portfolio return without taking unnecessary risk is diversification. You can combine exposures to asset classes and participate in their return by holding other asset classes along with them for risk protection.
In the chart below, each asset class is listed in its order of return for that year. So, in 2003, EM (Emerging Markets) Equity had the best performance, and Cash had the most nominal performance. You can also see that the range of returns reflecting what is “best” varies tremendously. In 2008, for instance, Fixed Income offered the best return as an asset class at 5.2%, and many of the asset classes had significant negative returns.
Fixed Income and Your Portfolio
Bonds are also known as fixed income. This type of investment means that you will receive a regular interest payment (coupon or just interest) from holding the investment. That alone makes them safer than equities as an investment because a large portion of your return comes from the interest payment — unlike a stock, where the largest portion of return comes from the market price.
You do purchase a bond at a market price, which fluctuates with the market. In the case of fixed income, one of the primary drivers of price is interest rates, as well as specific bond characteristics (e.g., maturity, credit and coupon rate). Interest rates matter a great deal to the price of the bond. When a bond is issued, the interest that it pays through coupon or other yield is similar to the prevailing interest rates. Therefore, as interest rates are rising, the price of the bond falls. As rates fall, the price of bonds rises, as we saw for the last 10-20 years. This is because the difference between the yield of the bond and the current interest rates creates an opportunity cost.
This relationship means that in the current economic situation, there are investors that are nervous about rising interest rates and the potential for falling bond prices as a result. It is important to remember that holding fixed income has several roles in a portfolio. Beyond contributing to the portfolio with the fixed income asset class’s own return and risk, fixed income provides diversification across the portfolio. The different pattern of returns helps cushion returns from equities and gives the overall portfolio a better risk-adjusted return.
It is important to note that there have been worries about rising interest rates for years. And in those years, fixed income offered a positive return to your portfolio. Just as you can’t forecast the stock market by looking in the rearview mirror, the same applies to interest rates. The path and timing of change is uncertain. How do you manage this in your portfolio?
Once again, you diversify by holding bonds with differing characteristics that respond to rising interest rates differently. The diversification of holding a broad selection will contribute to a portfolio return that is able to bear a variety of market conditions.
You can see in the bond market during periods of rising interest rates that bond returns are variable and often positive. We have no guarantee of the future performance of bonds. But holding a diversified bond portfolio contributes to your overall portfolio in two ways: the return (risk-adjusted) of holding the bonds themselves and the benefit to your portfolio diversity, allowing you to hold other, riskier assets that may offer a higher return.
Source: © 2018 Morningstar.1
*Current rate hike cycle is ongoing
Large Capitalization U.S. Stocks
Another asset class that is in the news this year is large cap U.S. stocks. This is for the opposite reason. Looking in the rearview mirror again, large cap U.S. stocks have outperformed many of the other equity groups. And this can happen, but it is not a persistent market effect.
In fact, merely from their capitalization, large cap stocks are a large allocation in a portfolio. But the reason that you can construct a portfolio favoring equities and large cap equities is that you include a wide variety of equity options. If you return to the block chart, you will find large cap stocks in olive green. You would note that in 2004 and 2008, this was not an attractive asset class relative to the other equity choices. Indeed, sometimes it is very attractive and sometimes it is not.
It is precisely that volatility that is managed by including a wide variety of asset classes in your portfolio. This gives you a good risk-adjusted return without the risk of a single asset class. And by investing in the broad array of asset classes, you have exposure to that asset class when it is doing well. Diversification is a powerful tool for your investments.
So how do you navigate market volatility? By holding a diversified portfolio of stocks and bonds that is also diversified within those categories — U.S. stocks and international stocks, large cap stocks and small cap stocks, etc. And in going back to our block chart, if you look at the path of investments in a fully diversified portfolio (labeled Asset Alloc in white), you can see that this is the one option that takes a path through the middle of the investments as the building blocks swing from gains to losses. This is the dual function of diversification: It allows you protection from the swings along with the ability to participate in all of the asset classes.
It is fruitless and typically quite costly to look in the review mirror as an investment strategy. As an investor, you are well-served by using the tools of diversification in portfolio construction, which allow you to participate in a broad array of investment asset classes due to the protection of the variability of each return. Diversify not just across asset classes but also within each asset class. Accessing all of these makes your investment more robust and provides a forward-looking approach to earn the most optimal risk-adjusted return.
Return data represent past performance and are not indicative of future results. Historical returns of indices do not reflect applicable transaction, management or other applicable fees, the incurrence of which would decrease historical performance results. Index information has been compiled by Wipfli Financial from sources Wipfli Financial deems reliable but has not been independently verified. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only. Indices are unmanaged. It is not possible to invest directly into an index. Different types of investments and/or investment strategies involve varying levels of risk, and there is no assurance that any specific investment or investment strategy will be suitable or profitable for any particular client’s portfolio. Diversification may not protect a portfolio from loss and does not guarantee profitable results. Losses can and do occur, and significant loss is possible. The individual funds that comprise a portfolio or composite may employ different strategies and have different risks associated with them.