Contributed by John Rice, CFA, CFP®, If you held a diversified portfolio during 2013 you probably experienced returns that were much less than the US stock market. This is because US stocks did phenomenally well during the year and many other assets were either flat or lost money. The US stock market, as measured by the S&P 500 stock index was up over 32% when dividends are included. The widely reported S&P 500 index does not include dividends so mass media will quote the index as being up 30% (29.6%).
If you had some of your money in asset classes other than US stocks, you very likely saw returns that were lower than 30% for the year. Bonds were mostly flat during the year as we saw some moderate interest rate increases that pushed bond prices down. Foreign stocks did not do as well as domestic stocks. And many other assets, such as gold and commodities, were down during the year.
We have long recommended diversification as a way of hedging against bad years in the stock markets. 2013 was a year when holding assets other than US stocks detracted from returns. You may recall that in the first part of the year many market forecasters were calling for a low single digit return on stocks or even a down year for 2013. There were many proponents of buying assets that were alternatives to US stocks. Low volatility versions of index funds, market neutral funds, and risk arbitrage products were hot during the first half of the year. You don’t hear these products mentioned as frequently after the market had such a strong showing during the year.
We have seen this before. In the late 1990s many people that were invested in other asset classes that were not US stocks saw diversification work against them. The years 1995 through 1999 the US stock market was up 20% or more each year for five straight years. Everyone said we had a new era upon us that justified higher valuations for stocks that was leading to higher price appreciations in stocks. That all came crashing down in the years 2000, 2001, and 2002.
Now we have seen several years in a row of strong returns again. Will this lead to another strong market downturn? One thing we know from history is that stock prices over-react to fundamentals. So if markets are going up, they go up more than the fundamentals warrant. And if they go down they also go down further than they “should” given the fundamental underpinnings of the companies.
This look at recent history has implications that are useful for the future. The main lesson is that professional investors cannot reliably predict how asset classes will perform over short periods of time. If you agree with this lack of forecast ability, the solution is to keep a well-diversified portfolio that contains hedges against possible downturns while still allowing you to participate in market growth, even if your growth is muted by the diversification into other asset classes.
The bottom line is that this time is not different. We will see future years where the stock market is down. Since we can’t reliably predict when that will happen the best strategy is to stay diversified into a mix of stocks and bonds and other asset classes around the world.
Your target allocation among asset classes should be established in an investment policy statement. Keep transaction costs and taxes low and rebalance to appropriate targets, as established in your investment policy statement.
Some years you will not perform as well as the stock market. Other years you will outperform the market. But overall your portfolio should be expected to provide you with a positive return that can provide you with income to achieve your financial goals.