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Prudence

Prudence can be a son-of-a-gun. You wear that bulky uncomfortable life jacket and never even fall off the boat. How many times have you wrinkled your clothes in the car from the snug seatbelt only to find your way safely to your destination? This is how diversifying an investment portfolio can feel sometimes. You take the sensible approach of spreading your investments over multiple asset classes only to watch as just a few of them soar, while the rest seem to drag down the overall performance in any given year.

The essence of diversification is feeling like you never own enough of the best performing asset class while always owning too much of the poorest performing asset class. Ah yes, prudence is a son of a gun. Let’s take a look at one of my favorite charts, the Asset Class Returns Quilt from JP Morgan Asset Management1. Asset classes are ranked from top to bottom by their performance during that year.  For starters, I’ve isolated the years 2013 thru September 30th, 2018 to show the recent dominance of US Large Cap and US Small Cap stocks. With the exception of a 2017 rally in Emerging Markets (EM Equity) and Developed International Markets (DM Equity), it may have felt a bit silly to own anything other than US Stocks. 

The natural temptation after almost 6 years of US dominance would be to trim or eliminate those investments that have underperformed and to use recent history to form an investment thesis for the future. Tempting as it may be, the evidence suggests it’s impossible to predict when the pendulum will swing the other way in favor of the next hot asset class.

Here, the same Asset Class Returns Quilt but for the period 2003-2012.

This timeframe was dominated by International Developed, Emerging Markets, and Real Estate Investment Trusts (REITs). For a period of 10 years, US Stocks mostly played second fiddle to their international counterparts. Even commodities showed a few strong years; something we haven’t seen much of coming out of the financial crisis.

When you take both periods and combine them, the results look like this:

If we were to take the chart back even further in time, we’d find the same thing - different asset classes performing and underperforming at different times with no useful pattern to inform us on how to successfully use this information to capture these moves. The stark reality is that one of the top performing asset classes in any given year is just as likely to fall to the worst in the next year as it is to repeat at the top.

The aim of diversification and asset allocation is to optimize return for a given level of risk over a full market cycle – recession, recovery, expansion, and contraction. You can see this in the consistency of the Asset Allocation (Asset Alloc.) portfolio in each of the charts above. It’s never at the top and never at the bottom.

An additional observation from these charts is worth mentioning. Traditionally, most investors have looked to bonds for protection against the downside risk of stocks, but stocks can also diversify the risk in bonds. Using the Year-to-Date numbers from the chart, we find high-quality bonds (Fixed Income) are negative 1.6% through September 30th while US Large Cap Stocks are positive 10.6%. Intuitively, a very conservative investor fears the volatility and uncertainty of stocks and may not want to include them in their allocation. However, this final chart from Morningstar reveals that over the period between 1970-2017 the minimum risk portfolio was actually a portfolio comprised of 33% stocks and 67% bonds2.

Yes, by adding stocks to a portfolio of bonds, portfolio risk was reduced and investment returns were increased over a 100% allocation to bonds. The essence of diversification is to own assets that zig and zag at different times. 

Being prudent means a good investment advisor always has something to apologize for in any given year. Similar to a life jacket or a seat belt, diversification is only appreciated when the benefit is realized - over long periods of time and through normal swings in economic conditions. Diversification is not only about achieving optimal risk-adjusted portfolio performance, it’s also about minimizing regrets from investing in a way that doesn’t suit one’s tolerance for risk. It’s this mismatch that can lead to destructive behavior when times get tough.

Keep playing the long game in transportation safety and investing.  You’ll be glad you did.

Happy Planning,

Brian

Data Sources / Disclosures

1. Source: JP Morgan Guide to the Markets (09/30/2018).  Underlying data sources: Barclays, Bloomberg, FactSet, MSCI, NAREIT, Russell, Standard & Poor’s, J.P. Morgan Asset Management.

Large cap: S&P 500, Small cap: Russell 2000, EM Equity: MSCI EME, DM Equity: MSCI EAFE, Comdty: Bloomberg Commodity Index, High Yield: Bloomberg Barclays Global HY Index, Fixed Income: Bloomberg Barclays US Aggregate, REITs: NAREIT Equity REIT Index.  The “Asset Allocation” portfolio assumes the following weights: 25% in the S&P 500, 10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EME, 25% in the Bloomberg Barclays US Aggregate, 5% in the Bloomberg Barclays 1-3m Treasury, 5% in the Bloomberg Barclays Global High Yield Index, 5% in the Bloomberg Commodity Index and 5% in the NAREIT Equity REIT Index. Balanced portfolio assumes annual rebalancing. Annualized (Ann.) return and volatility (Vol.) represents period of 12/31/02 – 12/31/17.

The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. The index

includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The S&P 500 Index focuses on the large-cap segment of the market; however, since it includes a significant portion of the total value of the market, it also represents the market.

The Russell 2000 Index® measures the performance of the 2,000 smallest companies in the Russell 3000

Index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

The Bloomberg Commodity Index and related sub-indices are composed of futures contracts on physical commodities and represents twenty two separate commodities traded on U.S. exchanges, with the exception of aluminum, nickel, and zinc.

The Bloomberg Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market. The index represents the union of the US High Yield, the Pan-European High Yield, and Emerging Markets (EM) Hard Currency High Yield Indices. The high yield and emerging markets subcomponents are mutually exclusive. Until January 1, 2011, the index also included CMBS high yield securities.

The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.

The NAREIT EQUITY REIT Index is designed to provide the most comprehensive assessment of overall industry performance, and includes all tax-qualified real estate investment trusts (REITs) that are listed on the NYSE, the American Stock Exchange or the NASDAQ National Market List.

All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses. All data represents total return for stated period. Past performance is not indicative of future returns.

Guide to the Markets – U.S. Data are as of September 30, 2018.

2. Stocks in this example are represented by the Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general and bonds by the 20-year U.S. government bond. Risk and return are based on annual data over the period 1970–2017 and are measured by standard deviation and arithmetic mean, respectively. Standard deviation measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.