Investors no doubt want to forget 2015. As my Bloomberg colleague Lu Wang aptly put it, 2015 was “The Year Nothing Worked.”
Well, not nothing. Diversification worked. If you were invested in a diversified portfolio in 2015, you didn’t make money, but you were protected from very painful declines in some corners of the global market.
The 60/40 diversified portfolio below, for example, was down 1.4 percent in 2015 – a year in which two of its components, emerging market stocks and commodities, were down 14.6 percent and 32.9 percent, respectively. One virtue of diversification is shelter from the storm, and it delivered in 2015.
So why fret? For starters, diversified portfolios have barely budged over the last two years. The portfolio above has only returned 2.2 percent annually to investors since 2014. On the other hand, the S&P 500 Index – the most widely followed market barometer by U.S. investors – returned 7.4 percent over the same period. Investors feel left behind.
Warren Buffett might have you do otherwise, though: trade your diversified portfolio for an S&P 500 Index fund. Buffett has already declared that 90 percent of the money he leaves to his wife will be invested in Vanguard’s S&P 500 Index fund (with the remaining 10 percent invested in short-term government bonds, presumably for liquidity).
Buffett is a well-deserved member of the investment world’s version of Mount Rushmore, but he’s wildly wrong to put almost all of his hard-earned eggs in the S&P 500 basket. I’m not the only one who thinks so. I’m not aware of a single portfolio built almost entirely on the S&P 500 – not Yale’s, not CalPERS’s, not the hallowed private wealth portfolios of Goldman Sachs, not the portfolios of your friendly local financial planner.
This is all for good reason because diversification, by insulating investments from market vagaries, creates more efficient portfolios over time. The 60/40 portfolio above returned 8.8 percent annually since 1988 (the first year for which returns data is available for all of its constituents), with a standard deviation of 10.7 percent and a Sharpe Ratio of 0.52. The S&P 500 Index returned 10.3 percent over the same period, with a standard deviation of 17.8 percent and a Sharpe Ratio of 0.40. (Standard deviation reflects the performance volatility of an investment, while the Sharpe Ratio is a gauge of risk-adjusted returns; a lower standard deviation indicates a less bumpy ride, and a higher Sharpe Ratio indicates that investors are more adequately compensated for the volatility they take on.)
Note, obviously, that the S&P 500 was both more volatile and less rewarding than the diversified, 60/40 portfolio.
The S&P 500 didn’t even provide the highest absolute return during the period! The MSCI Emerging Markets Index returned 10.5 percent annually since 1988, edging out the S&P 500 Index’s 10.3 percent annual return. This is no fluke. There are numerous asset classes that provide higher expected returns than the S&P 500 (among them asset classes that target factors such as value, size, quality, momentum and liquidity.)
A hundred years ago diversification meant assembling a portfolio of individual U.S. large cap stocks and bonds. Today diversification means assembling a portfolio of asset classes that stretch across geography (U.S., international, emerging, frontier), size and quality (large cap, small cap, investment grade, high yield), and the capital structure (bonds, mezzanine debt, preferred stock, common stock).
As the number of asset classes proliferate, so do the number of strategies that attempt to assemble them into a coherent portfolio. They go by names such as Markowitz (after Nobel Laureate Harry Markowitz, who introduced mean-variance optimization in the 1950s), Strategic-Tactical, Global Tactical Asset Allocation, Black-Litterman, Global Macro, and Risk Parity. There also are newer, unnamed strategies, such as those that allocate on the basis of valuation or momentum — or both.
Multi-asset portfolios are commonplace today, but they generally rely on a single strategy. Just as a multi-asset portfolio is more efficient than a single-asset portfolio, it stands to reason that a multi-strategy portfolio would be more efficient than a single-strategy portfolio. The reason is simple: When one strategy isn’t working, the others may pick up the slack.
Rather than revert to a single asset such as the S&P 500, my guess is that in the not distant future, portfolios will become multi-strategy rather than merely multi-asset. These multi-strategy portfolios will be a step forward, but no silver bullet. There will still be years when nothing works. There will still be periods when the S&P 500 is the best performer. In those periods the challenge will still be not to look at the S&P 500 with envy.
And if anyone tells you that nothing worked in the markets last year, tell them that you know of one thing that did: diversification.
Source: Bloomberg Gadfly, https://bloom.bg/2gW4eLs