Last year ended a nine year run of positive returns for the US stock market. As evidence-based investors, we know that investing involves risk, and that negative returns are always a possibility. A year like 2018 should not be unexpected, even if the timing of negative years is unpredictable. And while the magnitude of negative returns posted in 2018 was nothing out of the ordinary, 2018 was different in one respect, and broke a record going back to at least 1901 for the uniformity of negative returns across multiple asset classes. Simply stated, nearly all investments had a negative return in 2018, besides cash and short-term Treasury bills:
Investment grade corporate bonds were roughly flat last year, while US stocks fell about 5%, as did US REITs. Foreign equity markets fared worse with developed ex-US markets down 13.8% and emerging market stocks off by 14.6% in 2018. Even commodities suffered double-digit declines. These gloomy performance figures have been cited by many market participants as proof that diversification “failed” in 2018 and have even led some to complain that “nothing worked” last year.
Now if we confine our analysis to the somewhat arbitrary period of calendar year 2018, then some amount of complaining is understandable. But to some extent, 2018 is really the tale of two different markets; the first three quarters of the year vs. the final quarter. Viewed in this context, I think we can make the case that the benefits of diversification kicked in right when we needed them most.
Initially, US stocks performed very well last year, rising more than 10% by the end of September. A well-diversified investor with 60% in global equities and 40% in global bonds enjoyed a total return of about 5.5% by the end of September 2018. But market volatility spiked in the fourth quarter, and US stocks fell nearly 15% in three months. Foreign developed stocks fell about 13% and emerging stocks declined by about 8%. However, bonds had a very solid 4th quarter as global short-term bonds rose 1.3% and intermediate-term Treasury bonds gained 3.2%. Cushioned by a 40% allocation to global bonds, our hypothetical globally-diversified 60/40 portfolio fell by about half as much as the US stock market did in Q4. For the full year 2018, the 60/40 portfolio returned -3.2%, outperforming nearly all individual asset classes.
Performance figures from 2018 are an important reminder that diversification does not guarantee positive results in every period. (In fact, a diversified portfolio will always underperform at least one asset class, by definition!) Rather, the primary benefit from diversification is the reduction of risk. By lowering the overall volatility, diversification is the main tool that allows one to optimize a portfolio, maximizing return for a given level of acceptable risk. Downside risk was notably limited for diversified portfolios last year, showcasing again the benefits of diversification during periods of market turbulence.