Diversification in Difficult Times
Sometimes investors struggle when both stocks and bonds go down. Recently we’ve had a few clients ask about diversification during such times. Does it work? Is there anything else we can do? Today we’ll examine diversification. We’ll first show how diversification can limit the down quarters; then we’ll take a closer look at stocks last quarter and see how diversification worked during a tough period.
Since 1926, large US stocks have had negative quarters about one-third of the time. Bonds are less volatile than stocks, but still have had down quarters about one-fourth of the time.5 On average, we can – indeed should – expect at least one down quarter for stocks and one for bonds each year:
We can see that stocks and bonds don’t often go down together: it’s happened less than 10% of the time. Meaning diversification has worked. By owning stocks and bonds we likely reduce the times when most or all our portfolio assets are down.
What about within equities? Year-to-date we’ve seen a reversal of the COVID-based trend.6 This year value stocks have outpaced their growthier peers:
We can also see that small stocks went down more than large stocks, although the difference is much narrower than the chasm between value and growth. Overall, however, investors most likely faced a smaller drawdown with a mix of small and large, growth and value. This past quarter, diversification beat sticking with the same market segments that dominated the previous two years of the pandemic.
Diversification can frustrate investors. When large, healthy domestic companies are on top, it’s easy to wonder why we own anything else, especially more volatile small and value stocks. But when things turn the other way, as they did in the first quarter, having our proverbial eggs in different baskets can smooth some of the rough corners of a market downturn.
1 Global equities represented by the MSCI ACWI Index. All investment and index returns are from Morningstar unless otherwise noted. Past performance does not guarantee future returns.
2 US stocks represented by the S&P 500 Index. Foreign stocks represented by the MSCI EAFE Index (Net). Emerging-markets stocks represented by the MSCI EM Index (Net).
3 Foreign-value stocks represented by the MSCI EAFE Value Index (Net). Global infrastructure represented by the S&P Global Infrastructure Index.
4 US bond market represented by BBB US Aggregate Bond Index. Short bonds represented by the BBB US Govt/Credit 1-5 Year Index.
5 US stocks represented by the S&P 500 Index. Bonds represented by the Five-Year US Treasury Notes Index. Source: DFA and Wealth Architects.
6 Large growth: Russell 1000 Growth Index. Large Value: Russell 1000 Value Index. Small Growth: Russell 2000 Growth Index. Small Value: Russell 2000 Value index.
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