Market Update – First Quarter of 2022 Highlights the Importance of Diversification
The first quarter of 2022 was a challenging one for all types of investments. Stocks, bonds, and real estate investment trusts were all down. As we will see in this post, different types of investments perform differently over time. A diversified portfolio helps manage risk and maximize the return (or minimize the loss) relative to the risk you are taking with your investments.
First a little historical perspective. From 1926 through 2021, investments in a diversified portfolio of large company U.S. stocks had an average return of about 10.5%. For comparison, small company U.S. stocks had an average return of about 12% for the same period while long term U.S. government bonds had an average return of about 6%. These returns are commensurate with the risk of each of these investments as depicted below.
Data Source: Stocks, Bonds, Bills and Inflation (SBBI) 2021 Summary Edition and Ibbotson/Morningstar Data Set Through 2021
Small company stock investments have a greater amount of risk than large company stock investments (shown here using the standard deviation of returns) and therefore must be priced to offer a higher rate of return. On the other hand, U.S. government bond investments have a lower amount of risk than stock investments and therefore are priced to offer a lower rate or return.
Some other relevant information for the same period:
- If returns from large U.S. stocks is broken down between growth stocks and value stocks, value outperformed growth from 1926 to 2021.
- While returns from investments in real estate investment trusts (REITs) are not available for the full period, their returns have been between that of large and small company stocks for the period for which data is available.
- Investments in U.S. stocks represents about 60% of global capital markets (international/non-U.S. stocks represent about 40% of global stock market capitalization). Comparable data is not available for the 1926-2021 period but there is data on U.S. versus international stock investments for the 50-year period 1970-2020. Using 10 year rolling periods there were about 40 rolling periods during this interval. International stocks outperformed in most 10-year periods before 1995 while U.S. stocks outperformed in most 10-year periods since 1995. Overall, the two were very close with international stocks doing better in just slightly more 10-year periods.
Once again, the differences in returns are commensurate with the differing risks of these different investments. Generally, it should be expected that investments in smaller stocks and international stocks should provide a higher return due to their higher risks. Bonds on the other hand should provide a lower return than stock commensurate with their lower risk. However, this is a long-term perspective. Anything can happen in the short term; a month, quarter, year or even a 10-year period as we show below.
The graphic below shows returns of different types of investments for the period ending March 31, 2022. This table shows how different types of investments (also known as asset classes) have performed over the last 10 years. Investments in U.S. growth stocks outperformed all other investment types for the last 3-, 5- and 10-year periods. The S&P500 (a blend of growth and value) was in second place. Large company value stocks were ranked third in performance in the last 5- and 10-year periods, while commodities took third position for the last 3 years (basically due to their recent one-year performance). Note that over the last 10 years, commodities were ranked the lowest – not unexpected given relationship between commodity prices and inflation. The first column (YTD) shows the results of the first quarter of 2022. Commodities dominated performance while inflation and related higher interest rates negatively impacted all other investments. Hence, the widely held view that commodities are a hedge for inflation. Value stocks performed the best of all stock investments while growth stocks were the largest detractors from performance during the quarter. Bonds also suffered one of their worst quarters ever. (See my prior post What is Happening with Interest Rates and Bond Prices? – Robinson Global Investment Management LLC (rgimllc.com))
The changing colors over the different performance periods presented above highlights the importance of diversification. It is not possible to predict with a high degree of certainty which asset class will perform the best in any period. The shorter the period the more the uncertainty. Things can change rapidly in today’s global economy.
A broadly diversified portfolio that is based on meeting your investment goals, staying within your risk tolerance and considers the relative LONG-TERM expected returns relative to risk of different investments is the key to meeting your goals.
Please note that past performance is not a predictor of future performance. The next 95 years may not be like the last 95 years of data presented at the beginning of this post. Inflation, interest rates, economic conditions and company profits are likely to change. We can use the past however to infer relationships and help shape expectations. For example, relative to the past large stocks are currently priced higher than they have been compared to the historical data above, even with the market decline year to date. As a result, you should not expect large stock investments to average 10% in the future as they did in the past. Given current market valuations, future large company stock returns are more likely to be lower on average over the long-term. See for example the cyclically adjusted price earnings model examined in The Remarkable Accuracy of CAPE as a Predictor of Returns – Articles – Advisor Perspectives.