Throughout the last two years, investors have seen social and geopolitical events send the stock market into historic highs and lows. Each time the market takes a turn, many clients ask, “How do I preserve my wealth in this volatile market?” Our answer always starts with our investment principle of diversification.
The market events of the last two years can help us understand why diversification is vital to any sound investment strategy. Following the beginning of a world-wide pandemic in 2020, 2021 saw the creation and distribution of vaccines for Covid-19, and life in many areas of the world saw a gradual return to normality. The stock market seemed to head in only one direction: up. Annual returns for the S&P 500 in 2021 were 28%, driven by technology companies such as Nvidia, PayPal, and Apple. Technology seemed the theme of the year, with technology companies comprising over 30% of the S&P 500 by year-end, having outperformed the S&P’s annual performance by approximately 6%. That technology was going to outperform other slow-growing industries like Consumer Staples (Proctor & Gamble, Coca-Cola, Campbell Soup) and Utilities seemed obvious; commentators and investment managers alike cited their excitement and put a larger piece of their portfolios into technology companies.
Fast-forward to today and the S&P 500 is down nearly 12% year-to-date and technology companies in the S&P are down almost 19% year-to-date (as of stock market close on May 31, 2022). What has happened to those investors that unbalanced their portfolio by over allocating to technology last year? Wealth destruction.
No investment strategy works all the time, be it portfolios of stocks and bonds or 100% allocations to popular technology stocks. The only constant in investing is the need for diversification. While 2021 was the year of technology stocks, the start of 2022 has looked like the year of commodities (oil, metals, and agriculture); the Bloomberg Commodity Index is up 32% year-to-date.
The graphic below shows the relative performance of different asset classes over the last ten years. Which asset class will dominate in 2023? Only time will tell. The important takeaway is that by broadening the scope of portfolio asset exposures, investors reduce the likelihood of major drawdowns in a single asset class, helping to preserve wealth.
Graphic Source: May 2022 Eaton Vance Return Quilt
It's important to remember that diversification reduces risk, represented as volatility. Higher volatility means a greater risk of large drawdowns; a portfolio that suffers a 50% drawdown requires a +100% increase to return back to its initial value before halving.
With a diversified portfolio, the broadness of asset class exposures protects against an asset class disproportionately affecting performance. This brings us to another FAI investment principle: a diversified portfolio will always have “winners” and “losers”. Take the recent performance of commodities: oil and other commodities have seen incredible positive performance in 2021 and 2022. Why not just fully invest one’s portfolio in commodities? The returns quilt above shows the annual returns for major asset classes over the preceding decade; commodities returns are shown in light green. The track record of commodities has not been consistent, despite exemplary performance in recent years. Between 2012 and 2021, commodities were the worst performers in 6 out of 10 years.
Since we cannot time the market or predict which asset classes will be “winners” or “losers,” at FAI we are sticking to the one constant in investing – the need for diversification. For more information on FAI’s investment process, contact your advisor and read our 10 Investment Principles.