Looking back, diversification worked . . . over time

March 27, 2012 Categories: The Way Back Machine

Since the turn of the millennium, U.S. equities have returned 1.2% per year, as measured by the Russell 3000® Index; non-U.S. equities not much better, up only 2.8% per year, as measured by the MSCI World ex-U.S. Index. One dollar invested (with dividends reinvested) in U.S. equity on January 1, 2000, was worth $1.16 on December 31, 2011. That same dollar invested in non-U.S. stocks did twice as well, but still gained only 39 cents. Bonds fared better than both.

As a result, disgruntled investors are questioning many of the traditional tenets of investing, including the role of equities, risk versus reward, and portfolio diversification.

We know investor memories tend to be short and are prone to a “what have you done for me lately” mentality. Hopefully, this recent 12-year stretch doesn’t cause investors to abandon equities. For those considering it, a better perspective may come from examining the last four decades (as shown in the charts below), a period of extremes, but still representative of a 40-year investment horizon.

Growth of $1.00 by decade

U.S. Equity – S&P 500 Index, 1970 – 1978, Russell 3000® Index, 1979 – 2000; Non-U.S. Equity – MSCI World x-US Index; Bonds – Ibbotson Government Bond Index 1970 – 1975, BarCap Agg, 1976 – 2000; 60/40 Balanced Index Portfolio – 40% U.S. Equity, 20% non-U.S. Equity, 40% Bonds. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

The 70′s

The 1970’s included the tail end of the Vietnam War, oil embargoes, deep recession, and historically high inflation.3 A difficult economy, produced decent investment results.

  1. U.S. equities, at 6.4% per year, posted below historical norms
  2. Bonds produced average returns of 7% per year
  3. Non-US equity delivered 11% per year
  4. The diversified Balanced Index Portfolio more than doubled 

The 80′s

After a slow start due to high inflation and interest rates,4 the decade experienced strong results.

  1. U.S. equity assets more than quadrupled
  2. International equity assets sextupled
  3. Bonds paled in comparison, but still tripled in value
  4. The diversified index portfolio averaged 16.4% per year, a return on par with U.S. equity

This was the second decade in a row that non-U.S. equity led the markets and investors appeared to be taking notice. Those who hadn’t considered foreign equity in the past may have been looking to load up.

The 90′s

This period was poised to be the decade of Japan, but the bubble burst and the U.S. economy quickly stepped up. The U.S. markets hit their stride and investors may have reaped the benefits.

  1. U.S. equity dominated the decade
  2. Non-U.S. equity returns were solid
  3. The 60/40 Balanced Index Portfolio tripled 

Tripling your money over a 10-year period represents nearly a 12% annual return. However, given the outsized gains of the U.S. equity markets, diversification questions were cropping up at the decade’s end. Why do we want to own international stocks? Why do we want to own bonds?

Look back and plan ahead

We know why, because both international stocks and bonds did much better than U.S. stocks over the last dozen years. Still, it is impossible to predict the future. Market leadership can change abruptly, catching most by surprise. However, we may win by diversifying into asset classes that may not look attractive on the surface.

In hindsight, investors whose risk tolerance would have allowed for it, should have had more invested in international stocks at the start of this period. In reality, it took the two strong decades of the 70’s and 80’s to get investors to consider them seriously. Now they are a portfolio fixture, and deserve to be, along with fixed income and other diversifiers.

Growth of $1.00 over 40 years

U.S. Equity – S&P 500 Index, 1970 – 1978, Russell 3000® Index, 1979 – 2011; Non-U.S. Equity – MSCI World x-US Index; Bonds – Ibbotson Government Bond Index 1970 – 1975, BarCap Agg, 1976 – 2011; 60/40 Balanced Index Portfolio – 40% U.S. Equity, 20% non-U.S. Equity, 40% Bonds. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Diversification does not assure a profit and does not protect against loss in declining markets. However, during this 4-decade stretch, the diversified portfolio captured almost all of the return of U.S. equities at considerably lower volatility (standard deviation5 of 17.7% vs. 11.1%). Lower volatility enables investors to stick with their plans and not chase last year’s winners because they already have some of what won. In addition, they own some of what may win next year. That’s a portfolio that can work for your clients over their investment horizon.

1 Source: Russell 3000® Index

2 Source: MSCI World ex-U.S. Index

3 The history of recessions in the United States“,  by Kimberly Amadeo, About.com Guide of the New York Times Company, March 12, 2012.

4 The history of recessions in the United States“,  by Kimberly Amadeo, About.com Guide of the New York Times Company, March 12, 2012.

5 Standard Deviation is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. The greater the degree of dispersion, the greater the risk.

The Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The MSCI World ex-U.S. Index is representative of a broad measure of stock performance throughout the world, with the exception of U.S.-based companies.

Source for MSCI data: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

Barclays Capital U.S. Aggregate Bond Index (BarCap Agg) is a commonly used benchmark for determining the relative performance of bond or fixed income portfolios.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

RFS 7902-a

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