What Asset Diversification Looks Like, in One Chart
At the start of 2018, you would have been hard-pressed to find a financial expert who said cash would be the top-performing asset class for the year. Even in the depths of the Great Recession, there were still better growth options than cash. Cash, history has shown, is often the worst-performing asset class. Still, a review of history shows that one shouldn’t be surprised when the dark horse asset takes the throne.
That’s because we know that in any year, an asset class that has performed poorly in the past may perform better than all others and visa-versa. U.S. large-cap stocks, for example, may generate superior returns in a given year, but that’s absolutely no guarantee they will repeat that success. Just because cash hadn’t led all asset classes for more than a decade, doesn’t mean it won’t. That’s why it’s crucial for investors to maintain a disciplined approach to asset diversification.
Each year, we produce a rather colorful illustration of this point.
Every year, Northwestern Mutual stitches together something we affectionately call “the quilt.” It’s a color-coded chart that ranks various asset classes by their total return in a given year, ranked from highest to lowest. Mapping this over the span of 15 years produces a chart that looks something like the Periodic Table, or, a quilt. It’s a multicolored mess. It’s chaotic. There’s no way this quilt would ever win a blue ribbon at the county fair.
And that’s the whole point.
You can see years where emerging market equity returns (red) exceeded every other asset class by a longshot, only to be outpaced by every single asset class the following year. In 2017, cash alternatives (green) were the least productive place to keep a slice of your wealth. One year later, in 2018, cash alternatives outpaced every other asset class, even though the return was just 1.8 percent. No matter what patch you track across the chart, a similar story unfolds.
“Watch your frame of reference. Don’t just base investment decisions off a what-have-you-done-for-me-lately type of analysis,” says Brent Schutte, chief investment strategist at Northwestern Mutual. “We believe successful investors focus on winning the intermediate- to long-term game, not the short-game, which is impossible to consistently win.”
It boils down to this: While it’s possible to try to estimate the trajectory of the broad economy and different asset classes over long timespans (stocks outperform bonds over the long haul, for example), it’s nearly impossible to zoom in and predict which asset class will shine above others in the short-term.
“Strong global growth pushed emerging markets forward in 2017, only to have their reign at the top interrupted by short-term tariff and federal reserve fears in 2018. However, we believe this interruption will prove temporary as those fears recede in 2019,” says Schutte.
Take a little closer look at the quilt. You’ll notice there’s one square offering some semblance of consistency – it’s the white, diversified portfolio patch. Rather than a single asset class, the diversified portfolio is a melting pot containing every asset class on the quilt. It represents a portfolio with the following weightings: 23 percent U.S. large cap; 6 percent U.S. mid cap; 3 percent U.S. small cap; 13 percent international developed; 6 percent international emerging; 4 percent real estate; 5 percent commodities; 38 percent fixed income (bonds); and 2 percent cash alternatives.
It’s got a little bit of everything, which means it’ll hold the top-performing asset class and the worst-performing asset class at the same time. By its very design, the diversified portfolio will never take that top spot in returns, but it also won’t finish at the bottom. Rather, it has reliably produced middle-of-the-road returns relative to any single asset class. Over the course of decades, this consistency of returns can go a long way toward growing a retirement nest egg and helping mitigate your risk exposure to the ups and downs of any single investment in your portfolio. That’s the beauty of diversification.
SEEING RED IN THE PORTFOLIO, BUT NOT FEELING BLUE
But that’s not to say diversification is always beautiful.
“Most people agree that diversification is a positive, but when they actually experience it, they tend not to like it. It means you own something that isn’t doing well,” says Schutte. “But, counterintuitively, that’s actually a good thing. You don’t want all your oars on one side of the boat when the unexpected wave hits.”
If you looked at a diversified portfolio in 2008 and saw a negative 58 percent return for your emerging market allocation, you’d wonder why you owned emerging market equities at all. It’s not easy seeing steep losses in your retirement account, and it’s tempting to put that money into high-flyers. However, come 2009 you’d be patting yourself on the back for hanging on to those emerging market investments. You can easily see how trouble arises when you attempt to place your eggs in the top asset class every year.
Therein lies the main benefit of a disciplined approach to maintaining asset class diversification. It takes much of the emotion out of investing because the goal is to simply strike an allocation balance that’s appropriate for your age and risk tolerance level. It also helps hedge uncertainty – rather than betting on a single sector, you’re basically putting small bets on every single one.
Remember, it’s perfectly normal for certain asset classes in an investment portfolio to perform poorly, sometimes for several years. If it’s part of a systematic approach to diversification, you shouldn’t sell at a loss just because it’s not performing well. Contrarily, periods of underperformance may be just the right time to invest more and bring the weighting back in line with of your overall portfolio allocation plan.
Take commodities, for example. As an asset class they stick out like a sore thumb. They’ve posted more annual negative returns than positive for much of the past decade – the past few years have been particularly poor. Commodities are tightly correlated with the rate of inflation: When commodity prices rise, inflation rises; when prices fall, inflation falls. For the past several years, inflation has remained very low. However, there’s no telling how long that will remain true.
“Commodities hedge against inflation risk better than any other asset class,” says Schutte. “Commodity prices have kept inflation low, and thus bonds have seen positive returns even with low starting yields. Markets seem to be priced as if inflation is dead, but it could very well return. If that happens commodities will rise in price, and even a small allocation to this asset class could serve as a hedge.”
Although commodities have notched negative returns of late, it may be worth “paying” the price for this hedge against the unexpected rise in inflation. While other asset classes may struggle in an inflationary environment, that’s exactly when commodities will shine. And although you might be disappointed that your commodity returns were negative recently, that meant your bond returns were, in turn, positive. Sometimes, for every action in one asset, there’s an equal or opposite reaction with other assets throughout the portfolio.
As the quilt shows, those asset classes that were last shall (perhaps) be first, and vice versa. Every year there’s bound to be an asset class that surprises the investing world with its returns – or lack of returns. But, then again, that wouldn’t be much of a surprise at all.
All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.
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 MidCap 400 measures the performance of 400 mid-sized companies in the US, 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 (Europe, Australasia and Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
Int’l Emerging: The MSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of Europe, the Middle East and Africa. The Index consists of the following emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
Real Estate: The Dow Jones U.S. Select REIT Index intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.
Commodities: The Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, 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 Barclays Capital U.S. Aggregate Bond Index (formerly the Lehman Brothers U.S. Aggregate Index) is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
Cash Alternatives: Cash alternatives are represented by the Citigroup 3-month Treasury Bill Index, an unmanaged index representative of 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.
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