When a client asks: 'Why isn't my portfolio performing as well as the S&P 500?'

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Say you have a client who calls you, concerned, because her portfolio is not, at the moment, doing as well as the headline S&P 500 numbers she is seeing on the news. It’s up to you to illustrate how a diversified portfolio won’t simply mimic the S&P 500, but it can perform better over time, and with less volatility. With your help, clients should come to understand that portfolios must be diversified across multiple asset classes that ideally have low correlation with each other.

You can explain it like this: Building a portfolio is like putting together a basketball team. Each player brings a different skill or attribute to the team. It’s the differences between the players — not the similarities — that help form the best lineup.

Thus, if a portfolio only includes the 500 large-cap U.S. stocks that comprise the S&P 500, isn’t that kind of like building a basketball team by only having point guards, or only power forwards? Those are not diversified basketball teams. Similarly, investing in the S&P 500 does not make for a diversified portfolio.

Now to provide a demonstration, which you can share with your clients.

In “Diversify your diversification,” the starting point is a portfolio that only includes large-cap U.S. equities. Over the past 20 years, the average annualized return was 5.62%, well below the historical norm of roughly 10%. But that was the reality from Jan. 1, 1999, to Dec. 31, 2018.

During this period, the S&P 500 produced positive annual returns 75% of the time and had a standard deviation of annual returns of 17.48%. Its worst calendar-year return was 37% in 2008, at the height of the financial crisis.

Let’s start building our portfolio team by adding some other ingredients to large-cap U.S. equities. The result is an equally weighted four-asset portfolio that includes cash (90-day Treasury bills), U.S. bonds (Barclays Aggregate Bond Index) and small-cap U.S. stock (Russell 2000). Each asset class was given a 25% allocation and rebalanced annually.

With this portfolio, the 20-year return does decline slightly to 5.34%, but the portfolio volatility (as measured by standard deviation of return) plummets to 8.68%. This means volatility was cut in half.

Positive annual returns occurred 80% of the time, and the worst one-year loss was only 16.04%, compared to 37% if only invested in large-cap U.S. stock. Overall, an endorsement for adding more ingredients to a portfolio.

But we need not stop there. We will now add diversifiers to our portfolio team. The first is non-U.S. stock (MSCI EAFE Index). Each asset class now has a 20% allocation and is rebalanced annually.

As shown in the table, 20-year performance declined slightly to 5.14% and standard deviation ticked up from 8.68% to 10.94%. The percentage of positive annual returns fell to 65%, and the worst one-year loss increased to 21.51%.

Overall, foreign equities have been a party pooper asset class over the past 20 years.

If we added REITs (Dow Jones US Select REIT Index) as the diversifier asset class instead of foreign equities, the results were much better. The 20-year average annualized return for the five-asset portfolio jumped to 6.43%, or 81 bps higher than the S&P 500 by itself. Even better, the added return was achieved with 44% lower volatility.

Adding commodities (represented by the S&P Goldman Sachs Commodity Index) as the 5th asset diversifier hurt performance (4.89% 20-year return), but actually lowered the standard deviation of return more than when we added foreign stock.

What happens if we equally weight all seven asset classes? The 20-year performance is 5.67%, or 5 bps higher than the S&P 500 alone. This is rather amazing, inasmuch as the seven-asset portfolio had an overall asset allocation of 71% to equities and diversifiers, and 29% to fixed income. Yet it outperformed 100% equity. Plus, it achieved that slight outperformance while reducing volatility by 33%. Positive annual returns were achieved 75% of the time, and the worst calendar-year loss was 27.6%.

Looking at Longer-Term Results

The past 20 years paint a very supportive picture for broad portfolio diversification. How about over the past 49 years (from 1970-2018)? Since 1970, the S&P 500 produced a 49-year average annualized return of 10.21%, had a standard deviation of 16.98% and generated positive annual returns 80% of the time.

The equally weighed four-asset portfolio consisting of cash, U.S. bonds, large-cap U.S. stock and small-cap U.S. stock had a 49-year return of 8.75% and a standard deviation of 9.63%, and it produced positive annual returns 86% of the time.

If we add foreign stock as the 5th asset class, the return is 8.90% and the standard deviation 10.93%, and positive annual returns were generated 78% of the time. Real estate as the 5th asset class produced a 49-year portfolio return of 9.45%, a standard deviation of 10.42% and 84% positive annual returns.

Commodities as the 5th asset class generated a portfolio return of 8.86% and a standard deviation of 9.04%, and positive returns 88% of the time. Interestingly, commodities —while not enhancing performance — did the best job of lowering volatility and producing positive annual returns at the portfolio level. This is due to the low correlation between commodities and everything else in the five-asset portfolio.

Finally, if we combined all seven asset classes into an equally weighted portfolio (14.28% allocation to each asset), the 49-year return was 9.48%, the standard deviation was 10.23% and there were positive returns 86% of the time. The performance of the seven-asset portfolio was slightly lower than the S&P 500 (by 73 bps), but volatility was reduced by nearly 40%. Additionally, the multi-asset portfolio produced positive annual returns more often (86% to 80%).

The key takeaway here is simple: Clients should understand that diversification across multiple asset classes is just as important as diversification within each asset class.

Here’s to enjoying the upcoming basketball season.

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