This quilt screams the message “you can’t predict returns!” This week we take the allocation conversation one step further into diversification.

The best return for a 100% stock portfolio between 1926 and 2016 was +54.2% while the worst return was -43.1%. Over the same period, a 100% bond portfolio returned 32.6% best case and -8.1% worst case. In this case we’re talking about the broad definition of allocation: the percentage of stocks vs bonds in your portfolio.

But what about asset class diversification? This is the difference between your stocks being invested 100% in large caps versus spread over 10 different asset classes, i.e. large caps, small caps, international, emerging markets, etc. That makes a difference, too, a big difference.

I love the asset class quilt! The quilt below is from the article “Updating My Favorite Performance Chart for 2018” by Ben Carlson CFA. In Ben’s words:

  • Asset allocation is typically the most important aspect of portfolio management so understanding how the various asset classes performed is instructive when trying to understand your results.
  • This is a useful exercise to remind myself how difficult it can be to pick the best (or worst) performing asset class in a given year.
  • You can learn a lot about how markets function by looking at performance in this way.

You’ll benefit by reading Ben Carlson’s full article, but here I’ll pull out a couple of points that resonated with me:

  • This is the first time in 10 years cash has outperformed everything else.
  • If 2017 was the year that everything worked then 2018 was the year that nothing worked. All asset classes tracked here were up in 2017 while 8 out of 10 were in negative territory this past year…
  • Large cap U.S. stocks and REITs have been ultra consistent in this period…neither asset class has spent any time ranked below 6th… Mean reversion would dictate that eventually, they would spend some time towards the bottom of the list but good luck predicting when that will take place.
  • Even after the sub-par 2018 campaign, the 10 year returns for U.S. stocks are spectacular…

The performance of the U.S. market reflects Warren Buffett’s thoughts on “The American Tailwind” – see last week’s blog. At the same time, please note Carlson’s suggestion that “mean reversion” will kick in at some point – what goes up must come down but no one can predict when.

Typically investors allocate different percentages to different asset classes, for example, more to Large Cap and less to Emerging Market stocks. Carlson shows that evenly weighting each of the 10 asset classes would have returned 7.2% in the 10 years since 2009.

And what if you looked at 11 years to include 2008 when the market collapsed? That, for example, drops the return for Small Cap stocks from 15.0% to 8.8% – nearly in half.

The takeaway? (1) This explains why your returns may have disappointed last year, and (2) your allocation between stocks and bonds and your diversification between asset classes within those categories is important to the success of your financial plan. Check with your advisor if you have questions!