Finally, it’s over! The worst year of stock market performance since the Great Depression ended last Thursday with the S&P 500 down 37%. In 2008, there was no place to hide in the financial markets, right? Wrong. An analysis of the following chart presents yet another argument for the value of diversification in an investment portfolio:
The return on government bonds is not a misprint: 22.59%. An investor with a well-diversified portfolio and an appropriate asset allocation mix of stocks and bonds felt a vastly reduced sting from market declines as compared to a pure stock investor in 2008. This is another illustration of diversification increasing return and lowering risk.
Three other facts communicated in the chart are worth noting. First, across the board, value stocks outperformed growth stocks in 2008. Consequently, most portfolios may need to be rebalanced because they are likely heavy on value and light on growth. Rebalancing should prepare your portfolio for a market rebound. Second, much like during the bursting of the tech bubble and after 9/11, international stocks did not protect an investor from losses. As a result, investors should consider the possibility that international stocks alone do not provide sufficient down-side protection. Such protection in down markets is more likely to be achieved with thorough diversification. Third, note that cash (treasury bills) did not keep pace with inflation, and cannot be considered a productive safe-haven for funds over time.
Sector allocation was a large factor last year. The “best of the bad news” came from the consumer staples industry, which lost only 15%. Not surprisingly, the finance sector was the worst performing sector during the year, losing nearly 50%.
The stock market has never lost money over the period of a decade. Even during the great depression of the 1930’s, the market squeezed out a small gain. However, the S&P 500 (all large cap stocks) has returned an annual rate of negative 3.5% during the first nine years of the twenty-first century. Losing 3.5% each year doesn’t sound like much, but if an investor placed $1,000 into the market the first day of 2000, the account would now only be worth $693. In fact, the S&P 500 needs to earn an astounding 40% return in 2009 to make investors whole for the decade.
The benefit provided by diversification is clear. Using the index funds above, a portfolio consisting of 50% large cap, 20% mid cap, 10% small cap, and 20% international stocks has only lost 1.85% annually since 2000 and needs only an 18% return in 2009 to break even for the decade. By further diversifying your portfolio with 70% stocks and 30% bonds, an investor has already earned a positive 1.67% during the 2000’s. Bottom line: constructing a balanced portfolio and rebalancing often will improve a portfolio’s performance and reduce volatility.