A Volatile Year Serves as a Reminder of Why Diversification Matters

As we look back on 2022, it’s fair to say it was a historically challenging year for investors and the economy. Inflation reached highs not seen in 40 years, the Federal Reserve raised rates seven times by a total of 425 basis points — the most in a 12-month stretch since the early 1980s — and in a rare twist, equities and bonds both posted negative returns in 2022. If you're feeling a little dizzy after such a volatile year, it’s understandable. But while investors had to adjust to a vastly different environment than they faced in 2021, one constant remained — the annual reshuffling of performance rankings for the asset classes. As has been the case for the past 15 years, 2022’s winners and losers list looks much different than it did at the end of the previous year. 

The surge in demand for goods that began in 2021 continued during the first few months of last year, providing fuel for already high inflation. While price pressures on the goods side of the economy have eased considerably since peaking on a year-over-year basis in February, a shift in spending toward services led to rising price pressures for things such as airfares and restaurants. And while inflation had shown meaningful signs of easing in the second half of 2022, elevated energy prices throughout much of the year resulted in Commodities being the top performer of 2022, up 16.1 percent. This marks the second consecutive year of strong performance for the group; however, the back-to-back gains for Commodities were an exception, not the rule, among the various asset classes. In fact, negative returns were widespread, with Cash as the only other asset class to post positive performance during the period, as most of 2021’s winners stumbled. 

For instance, Large-Cap equities, as represented by the S&P 500, have been viewed by many as the asset class of choice due to the perceived safety that comes with the size of the companies in the index and its relatively strong performance during the past five years. But after finishing 2021 as the second leading performer, the group finished 2022 near the bottom — with only REITS and Emerging Market equities faring worse. A closer look at the underlying performance of Large-Cap stocks highlighted a renewed sensitivity to prices paid for companies. S&P 500 value stocks outperformed S&P 500 growth stocks for the first time since 2016 (and by the largest amount since 1999), with value down 5 percent compared to a loss of nearly 30 percent for growth companies. 

“This is something we’ve emphasized in our communications with clients — the valuations seen in what we call the “hopes, dreams, themes and memes” stocks were unsustainable,” says Brent Schutte, Chief Investment Officer of Northwestern Mutual Wealth Management Company. “Instead, we believed that investors would shift their focus from speculation toward a focus on cheaper stocks of companies operating in sectors producing cash flows and earnings in the here and now.” 

Likewise, REITS, which were at the bottom of the heap in 2020, handily outperformed the field in 2021 but were once again the worst-performing asset class in 2022. The volatility of the past 12 months serves as an important reminder that leadership is fickle and can change dramatically from one year to the next.   

"The stumble for Large Caps likely took some investors by surprise, given the group’s strong performance in recent years. However, over the longer term, the asset class has had its share of challenges. From 1998 through 2012, large cap stocks finished in the top third of asset class performance only two times. Since 2013, they have been a top-third performer in eight of the past 10 years. Over the course of a decade, investors have gone from avoiding large cap stocks to overweighting them in their portfolios. Diversification helps solve this all-or-nothing mentality and can help steer investors away from potential pain caused by chasing performance,” says Steve Bruce, senior investment consultant at Northwestern Mutual. 

Energy sends commodities higher 

While the Commodities asset class was a top performer for the year, strength was concentrated with energy, making sharp gains and lifting the group as a whole. Global prices for agricultural commodities were up only modestly, and industrial metal prices as a whole finished the year down. 

Precious metals also declined (gold was down 0.28 percent for the year) despite the rise in geopolitical risk. Gold serves as a haven for investors, particularly in an environment with negative real (inflation-adjusted) interest rates, and while off modestly for 2022, held up better than other asset classes viewed as hedges against inflation.  

“Despite commodities being generally unpopular with many investors, largely due to their performance struggles during the disinflationary stock and bond bull market of the 2010s, we view them as an important source of diversification,” Schutte says. “Their performance over the recent past, especially during 2022 when both equities and bonds were down, should serve as a reminder to investors of their historical and possible future value.”       

The case for diversification 

Following the close of every calendar year, we review the performance of various asset classes featured in what we call “the quilt.” It’s simply a color-coded chart that ranks, from highest to lowest, the returns of various asset classes each year. When you map it out across 15 years, you get something that looks like a hodgepodge of colors, or a crazy quilt that’s been stitched together with no rhyme or reason. The chaotic picture it creates vividly illustrates the unpredictable nature of markets and the importance of portfolio diversification for the long term.

As the saying goes, everyone likes a winner, and perhaps nowhere is that more true than when it comes to investing. For that reason, investors often are tempted to chase yesterday's top performers and shun asset classes that have struggled in the recent past. But a closer look at the quilt shows why this approach can have a lasting negative impact on the success of your comprehensive financial plan. Consider what happened following 2018 — the last time equities posted negative returns for the full calendar year. Cash went from king in the down year of 2018 to the bottom of the heap when markets subsequently recovered in 2019. Conversely, Mid Cap equities were in the bottom third of performance during 2018 but took second billing the following year. Now, this isn’t a call to indiscriminately sell last year’s winner and bulk up on the laggards; rather, a well-constructed portfolio holds a variety of asset classes to capitalize on gains in different areas of the economy as well as protect against unanticipated challenges. 

"You often hear that your time in the market is ultimately more important than timing the market — diversification is a guiding principle of that statement. It simultaneously acknowledges that it is impossible over the long run to consistently pick the top-performing asset class, and it reduces the risk of catastrophic losses that can derail an investor’s future financial plan," says Bruce.   

Diversification, despite the difficulties of 2022, fundamentally remains the best path forward for investors to deal with the market’s uncertainties. While we’ve heard talk that the challenges created by COVID spell doom for the time-tested 60/40 portfolio, we believe this view is misguided. A look at the quilt shows that a 60/40 asset allocation (labeled Diversif'd Portfolio on the quilt) has provided investors with consistency over the years. Despite recent talk of its demise, the 60/40 portfolio produced returns of 2.38 percent and 3.76 percent, respectively, on a three-year and five-year annualized basis. While single-digit returns may not seem impressive, it is worth noting that the 60/40 allocation outperformed five of the nine asset classes in our strategic asset allocation. As such, we firmly believe a 60/40 portfolio, which includes exposure to equities, fixed income and real assets such as commodities, can serve as a sound foundation on which to build. 

Looking forward 

As we look ahead to how the next 12 months will play out, it’s worth keeping this asset class performance chart in mind. Inflation is waning, but recession risks are rising and are likely to play out in a rolling manner throughout the economy, with industries seeing economic weakness and recovery independent of one another. Additionally, the Fed is likely to eventually pause its rate hike cycle as the economy and employment market soften. These are just a few potential scenarios visible on the horizon, but as we’ve all been reminded repeatedly since the arrival of COVID, there are always unexpected events that ripple through the markets without warning. The future is unknown in the near term; however, over the intermediate to long term, it’s possible to build reasonable forecasts based on historical trends and the trajectory of the broader economy.  

It’s easy to focus on performance and have a narrow view on particular asset classes, but that approach carries risk for investors. Diversification is key and may be critical now more than ever as we look ahead. A smart investment strategy leads with a steady outlook and looks through an objective lens that incorporates valuations and considers where we are in the economic cycle, the forward path of monetary and fiscal policy, and market structure. Additionally, the best financial plans include a focus on risk. That’s because true wealth is often gained during bad times, not good ones. Those who sell stocks during a downturn lock in losses. People who are forced to go into debt to pay for an unexpected expense may rack up additional costs in interest payments as opposed to people who have other sources they can tap to cover an emergency expense. 

“Having a segment of wealth in a tax-favored, non-correlated asset — such as permanent life insurance or an annuity — can offer investors the flexibility to meet their liquidity needs during times of market volatility,” says Bruce.   

In retirement or when facing an unexpected financial crisis, knowing that you have an emergency cash reserve, permanent life insurance cash value (which doesn’t rise and fall with the markets) and (if you’re in retirement) steady income from an annuity means that you can ride out temporary dips in the stock market. Not only does a balanced approach provide peace of mind, but a recent study has also shown that it makes a positive impact on long-term results. 

That’s the key benefit of diversification, and those who stick with it may be in a stronger position in the long run — especially given that markets are likely to continue to vary from one year to the next.  

The primary purpose of permanent life insurance is to provide a death benefit. Using permanent life insurance accumulated value to supplement retirement income will reduce the death benefit and may affect other aspects of the policy. 

*Compounded returns are measured by the geometric mean of a given portfolio, which takes into account the sequence of returns over a given period of time and more accurately shows the portfolio’s performance over that period of time, as compared to a simple average. **Risk is represented by standard deviation, which is the measure of total volatility in a portfolio. It shows how widely a portfolio’s returns have varied around the average over a period of time. Standard deviations on this chart were calculated using monthly returns.  

Sources for asset class chart: 

U.S. Large Cap: The S&P 500® Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. 

U.S. Mid Cap: The S&P Mid Cap 400® Index measures the performance of 400 mid-sized companies in the U.S., reflecting this market segment’s distinctive risk and return characteristics. 

U.S. Small Cap: The S&P Small Cap 600® Index is a market-value weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation. 

Int’l Developed: The MSCI EAFE® Index Net Total Return measures the equity market performance of developed markets (markets domiciled in high-income countries, as defined by the World Bank, that most investors consider having a well-developed operating and regulatory structure for its capital markets), excluding the U.S. & Canada. The index returns are calculated with reinvestment of net dividends after the deduction of applicable non-resident local withholding taxes. 

Int’l Emerging: The MSCI Emerging Markets® Index Net Total Return measures the equity market performance of emerging markets (markets domiciled in lower-income countries, as defined by the World Bank, but are experiencing rapidly developing economies). The index returns are calculated with reinvestment of net gross dividends after the deduction of applicable non-resident withholding taxes. 

Real Estate: The Dow Jones U.S. Select REIT Index is composed of companies whose charters are the equity ownership and operation of commercial real estate and that operate under the REIT Act of 1960. Each REIT in the REIT Index is weighted by its float-adjusted market capitalization. The total return version of the index is calculated with gross dividends reinvested. 

Commodities: The Bloomberg Commodity Index (BCOM) is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements. 

Fixed Income: The Bloomberg U.S. Aggregate Index measures the performance of investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS. It rolls up into other Bloomberg flagship indices. 

Cash Alternatives: Cash alternatives are represented by the FTSE 3-Month Treasury Bill Index with income reinvested, representative of the three-month Treasury bills. 

Diversified Portfolio: A portfolio of all segments disclosed above, with the following weightings: 23% U.S. Large Cap; 6% U.S. Mid Cap; 3% U.S. Small Cap; 13% Int’l Developed; 6% Int’l Emerging; 4% Real Estate; 5% Commodities; 38% Fixed Income; 2% Cash Alternatives.