As early as the 17th century there was the advice to not put all your eggs in one basket. Taking the opposite stance was Mark Twain, who said: “Put all your eggs in one basket and then watch that basket!” With all due respect to Mark Twain, clients don’t hire us to swing for the fences. They’ve made their money and want to see it continue to grow responsibly. This means spreading out your risk. In investment terminology, it’s called diversification. While there are different types of diversification, we’ll focus on the asset class version today.
U.S. stocks can be segmented by size into large, mid, and small companies. International stocks can be developed or emerging. We put real estate in its own class, while fixed income can broadly be segmented as investment grade bonds and high yield bonds (not to mention taxable and tax-free). Then there’s cash, which technically is an asset class, but due to inflation, a poor investment over the vast majority of time periods.
When we build portfolios we generally include most of the asset classes listed above. The reason is twofold: 1) over time each one will have its day in the sun, and 2) they tend not to move in lockstep with each other. This means by building a diversified portfolio it’s possible to lessen the risk (measured by standard deviation) without sacrificing as much in the way of performance.
Every one of the asset classes listed above has either led the pack or been in second place during a given year over the last decade and a half. Each of these assets has also spent at least one year in the bottom two of the performance table. Predicting which asset class will lead in any given year is a bit like forecasting the temperature in Nebraska in March six months out. It could be 20 degrees, or it could be 80 degrees.
For example, international stocks underperformed U.S. large caps in 2013 and 2014, causing investors to question why they even own foreign companies. But international and emerging markets stocks beat their U.S. counterparts in six of eight years from 2002-2009. REITs rebounded from the financial crisis to take the top spot from 2010-2012. And small-cap stocks beat large cap in 11 of the past 15 years, outpacing their big brothers by over 3% annually.
Overall, real estate investment trusts (REITs) were the best performing asset class for the last 15 years with an annual return of 12.68%. High yield bonds were second at 7.54%. Tied for 3rd place are emerging markets and small-cap stocks at 7.38%. High-grade bonds returned 5.7%. The S&P 500 returned 4.24% on average over this time period, with international developed stocks coming in at 2.97%. The worst performer was cash at 1.24%. (Disclaimer: Past performance is not indicative of future performance.)
With large-cap stocks performing well relative to other asset classes, investors expect them to continue to do so. Don’t succumb to recency bias, a behavioral finance concept that states we have a tendency to put more weight on recent performance. As we’ve shown, a single asset class doesn’t stay on top for long. It pays to diversify.
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