The Year Diversification Failed

Most of you reading this are no doubt disappointed in your investing performance for the year, and rightfully so. Usually we count on the benefits of diversification to provide one of the few free lunches in investing: mix together different asset classes and experience lower volatility with similar returns. What’s not to like; less volatility, same returns!
 
Some might say this year diversification failed. Not one major asset class had a significant positive return. Most major US and international stock indexes were down, some in the double digits. Even the stalwart hero of the conservative portfolio, the aggregate bond index was basically flat for the year. Gold and Silver, the supposed safe haven assets in a crisis, were both down: -2% and -9% respectively. (Client note: since we have been expecting interest rates to rise in the last couple of years, our portfolios have mostly short duration bonds. These bonds have returned 1.5-2% this year.  For a refresher on bond math, click here)

You can take a quick look at the chart below from Bespoke Investment Group to survey the return landscape. The winners (if you can call them that): The yen, healthcare and natural gas. I’m guessing that not many would have predicted that last year.

How did this happen?
 
2018 was a tale of two markets. Although volatility picked up significantly in 2018, most major markets were up through September. Then they were absolutely clobbered from October onward. Why? No one knows for sure. There is a list of bad news to pick from: trade wars, tariffs, populist governments, slowing global growth, etc. I’m sure that all of these have contributed to the recent market turbulence.
 
But if, like me, you believe that market performance over the last 10 years has been driven largely by intervention of the Federal Reserve and other Central Banks around the world, then today’s market volatility is certainly not very surprising. We have conducted the world’s greatest monetary experiments: zero interest rates (negative in some countries) and quantitative easing for almost ten years. Now that these programs are unwinding around the world, is it surprising that things are getting more volatile? In other words, if the central banks have been so instrumental to investment returns, we should not be surprised if returns drop now that support is easing.
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Where to go from here?
 
It is impossible to know how markets will fare. These types of interventions have literally never been done before on this global scale. I would be skeptical of anyone claiming to know how this will turn out. A little over a year ago, I wrote a note where I encouraged prudence for 2018 (you can review here). I think that prudence remains the key watchword for 2019. I expect volatility to remain high and would not be surprised to see continued market drops.
 
Perhaps we should say that it seems as though diversification has failed this year, because diversification only works over time. Based on market history, we should expect market corrections of 10% or so every year. And corrections of 20% or more to happen every three or four years. Part of your our strategy should be use the corrections to our advantage and buy assets when prices are low. I want to show you the following chart from the Motley Fool. It shows returns after market corrections:

As you can see, after market drops, the odds of stocks being higher in five years go up significantly. So one way to look at the current scenario is that while short-term returns have been poor, the odds have increased that long-term returns will be better.
 
Together we have developed a risk-appropriate diversified portfolio, so the path forward is simple: stick to your strategy. Your asset allocation strategy is designed to take advantage of this volatility. For a refresher on how this design works, click here). Although it will be uncomfortable, using these types of market corrections to sell the assets that have performed well (or at least less badly!) to buy assets that have done poorly recently is the key to the success of your strategy over the long term. 
 
Having a strategy is important. But equally important is having the fortitude to stick with it during times of turbulence. Diversification may not seem to have worked well this year, but I believe that it will continue to pay dividends in the future as it has done in the past.
 
Feel free to reach out if you have questions, concerns or if you’d just like to chat.