“Free and Easy Down the Road I Go”-Dierks Bently
Jim Shellenberger, CFA | Financial Advisor
By the very definition of investing, we set aside money to build wealth over time. Most of us approach an investment and hope to make money or “let our money go to work for us.” Ideally, we make money with minimal ups and downs (volatility). Generally, this goal can, in part, be accomplished through diversification. Diversification is an investment approach that seeks to reduce exposure and risk to similarly behaving asset classes by combining a variety of investment options as a pool of assets. It’s basically the epitome of the simple advice we’ve all heard “don’t put all your eggs in one basket”. Additionally, in theory, some investment options should react differently to the same event. I wouldn’t describe anything in investing as “free and easy,” but in an ideal world, diversification in your investments can help you feel “[confident] and easy down the road I go.”
There Hasn’t Been a Consistent “Easy” Choice: When looking year to year, different asset classes outperform and underperform each other. The chart below is a great visual representation of how various asset classes perform against each other, on an annual basis. You can see that among the asset classes below, no category was top-performing over consecutive years. Long-term treasuries and aggregate bonds usually did best when stocks were negative. This type of behavior is what our research would suggest and reinforces our belief in diversification. You want different asset classes to act differently to each other depending on the market environment.
Source: Morningstar. This example does not represent all asset classes.
Smooth the Ride. When you look at the chart above, you can see there is some risk in placing all your money in a single asset class, especially since the future is unpredictable. Investment professionals can make educated forecasts, but things like pandemics and other Black Swan events are difficult to foresee. If you look at the chart below, we took the different equity asset classes from above (US large, US small, international large and emerging markets) and graphed them from 2001 to 2019. The bold black line is an example of a diversified portfolio with equally weighted positions of the four categories. It was the second-best performer over the time period, only behind emerging markets. This illustration goes to show the power of diversification and how a simple equally weighted portfolio could have increased your chances of a better return.
Source: All calculations by Frontier
Diversification to The Rescue. 2020 started as one of the strangest years in recent history for the stock market and things are still not back to “normal”, whatever that is. We all know the stock market was not spared from the chaos as stocks took a big hit, but diversification was there to help. In the chart below, you can see the returns for the different broad asset classes for the first quarter of 2020 and from the beginning of the year through the end of June. All the equities were down over 20% during the first quarter. Aggregate bonds were up about 3%, and impressively, long-term treasuries were up about 21%. People often ask me about bonds in their portfolios. In moments like this, when things work out as expected, bonds can be useful in that they often react differently to the same event and can help offset losses.
Source: All calculations by Frontier from Morningstar data.
Diversification is not the answer to everything in investing, but we believe it is a necessity for building a healthy, long-term portfolio. Our goal is to try to anticipate the return, volatility, and correlation of the asset classes to build a portfolio that seeks to maximize return for a given risk level. Hindsight is 20/20. So, until we discover a crystal ball to unlock the mysteries of the future, we will rely on diversification to help us say “[confident] and easy down the road I go.” Enjoy the ride.