Wide Disparity in 2014 Stock Returns Shows the Importance of Diversification
With another calendar year in the books, investors can look back to 2014 and see the vast disparity between asset classes, with the U.S. markets leading the way for a second consecutive year. Why not then just take the simple approach of investing in the S&P 500 Index? The answer is that we don’t know which asset class will be the top performer from year to year. Looking back on the past 15 years, the U.S. has only led three times, with all three coming since 2011, hence the reason for the initial question.
At Bronfman E.L. Rothschild, we believe that a diversified approach to investing across different regions of the world and different size companies is the best approach to meet portfolio goals.
A look back at 2014
With another calendar year in the books, investors can look back to 2014 and see the vast disparity between asset classes, with the U.S. markets leading the way for a second consecutive year. Why not then just take the simple approach of investing in the S&P 500 Index? The answer is that we don’t know which asset class will be the top performer from year to year. Looking back on the past 15 years, the U.S. has only led three times, with all three coming since 2011, hence the reason for the initial question.
At Bronfman E.L. Rothschild, we believe that a diversified approach to investing across different regions of the world and different size companies is the best approach to meet portfolio goals.
Global Equity Market Returns – Past 15 Years
Source: MSCI, Morningstar. Europe: MSCI Europe Index U.S.: MSCI USA Index Japan: MSCI Japan Index EM: MSCI Emerging Markets Index
A more granular look at 2014 shows the differences even between large cap versus small cap U.S. stocks. We also have provided returns for target risk allocation indexes that Morningstar provides. These give a look into what a well-diversified portfolio may have experienced in 2014.
As stated above, we believe that a portfolio of investments diversified across several asset classes is the best approach. However this approach is not immune from under-performing certain benchmarks from year to year. For example, the Morningstar Moderate Risk portfolio returned 4.89% in 2014, compared to 13.69% for the S&P 500 Index, as shown in the tables below.
2014 Review – Various Market Indices
*Returns in U.S. dollars
Source: Morningstar
Looking forward: building a diversified portfolio
Given the wide range of results we see looking backward, the natural question is how to go about building an optimal portfolio of stocks and other asset classes.
Critical to that portfolio planning process is understanding investors’ risk preferences, time horizons, and other personal factors. We combine that investor-specific data with forecasts for asset classes to build portfolios. For example, the image below shows several hypothetical portfolio allocations made up of the asset classes shown at left.
In the graphic, note how the percentage of constituent asset classes changes as the portfolio gets more risky (higher standard deviations) overall. For example the proportion of the left-most portfolio—with the lowest expected risk—is 18% Broad U.S. Equity. The right-most portfolio, with the highest level of expected risk, includes a higher concentration of stocks, with 34% in Broad U.S. Equity.
Here is some additional information from our partner, Callan Associates, on its team’s process to build expectations for a range of outcomes for various asset classes. This process, together with careful and comprehensive attention to investors’ personal factors, helps us allocate efficiently.
- We forecast three primary figures for multiple asset classes: a mean rate of return, a corresponding range defined by standard deviation, and the correlations between asset classes. These figures represent our best thinking for long-term expectations and establish a mid-point within a wider range of potential outcomes. We use the projections to model portfolios for our clients. Multiple elements of the capital markets influence the projections—returns relative to inflation, equity valuations, risk premiums, GDP growth, and many other factors. These projections incorporate advanced quantitative modeling as well as qualitative feedback and the economic expertise of Callan’s consulting professionals. Our current numbers reflect our optimism for the economy, for inflation, and for the capital markets.
- In the past, particularly in stressed markets like 2008, correlations among asset classes have risen. Among the risky asset classes, correlations are high and will remain high. Callan revisits and adjusts our correlation expectations annually. Recently we have made risky, equity-like asset classes more correlated looking forward. Interestingly, stocks and bonds have exhibited tremendous negative correlation over time. Other uncorrelated asset classes have been commodities, TIPS, and to some extent many absolute return strategies. We believe real estate will maintain a diversification benefit, but it’s harder to measure given the valuation process.
- Returns for major asset classes over the past six calendar years reveal pockets of short-term volatility. Returns for longer, cumulative time periods remain the focus for institutional investors.
Conclusion
Disciplined portfolio construction, with investor-appropriate diversification across asset classes, can provide benefit over the long run. Although it’s natural to look backward at winners—such as large-cap U.S. stock in 2014—and think it would have been nice to achieve those returns overall, the better path is a carefully built portfolio that takes into account potential risks and returns across a wide range of assets. Because we don’t know what the number one performing asset class will be, over time, this disciplined approach can pay off.
Bronfman E.L. Rothschild, LP is a registered investment advisor. Securities, when offered, are offered through Baker Tilly Capital, LLC, member of FINRA and SIPC; Office of Supervisory Jurisdiction located at 10 Terrace Court, Madison, WI 53718, phone 800.362.7301. Bronfman E.L. Rothschild, LP and Baker Tilly Capital, LLC are not affiliated.
Callan Associates is headquartered in San Francisco with four regional offices. Callan is the third largest independent institutional consulting firm in the U.S. specializing in providing in-depth research on over 200 investment management firms. Callan oversees $2 trillion in pension assets. Bronfman E.L. Rothschild is one of a small group of independent Registered Investment Advisors granted access to Callan’s full capabilities and is served by Callan’s team of 38 relationship managers and analysts. Our combined teams deliver one of the largest, most analytically capable, and timely research resources in the world. Bronfman E.L. Rothschild, LP and Callan Associates are not affiliated.
The Morningstar Target Risk Index series consists of five asset allocation indexes that span the risk spectrum from conservative to aggressive. The family of asset allocation indexes can serve as benchmarks to help with target-risk mutual fund selection and evaluation by offering an objective yardstick for performance comparison.
This publication should not be viewed as a recommendation, an offer to sell, or a solicitation of an offer to buy a particular security or service. The commentary provided is for informational purposes only and should not be relied on for accounting, legal, tax, or investment advice. Financial information is from third-party sources. While such information is believed to be reliable, it is not verified or guaranteed. Performance of any indexes is provided for reference and competitive purposes only without factoring any fees, commissions, and other charges. Individual results achieved by investors will be different from those of the indexes. Indexes are unmanaged; one cannot invest directly into an index. The views and opinions expressed are those of Bronfman E.L. Rothschild, LP, and they are subject to change at any time. Past performance does not imply or guarantee future results. Investing in securities involves risks, including possible loss of principal. Diversification cannot assure a profit or guarantee against a loss. Investing involves other forms of risk that are not described here. For that reason, you should contact an investment professional before acting on any information in this publication.
© 2015 Bronfman E.L. Rothschild, LP
