In 1997 and 1998, emerging markets and commodities crumbled. But the pain was offset by gains in U.S. and foreign developed markets stocks. Bonds did well in those two years too.
During the great bear market of 2000-2002, stocks in general were bleeding. REITs offered a rare exception, posting tidy gains in those otherwise dark three years for the stock market. Another bright spot in 2000-2002: In two of the three years, commodities posted solid gains and bonds did well too.
Diversification, in short, has proven its worth in the recent past. The question is whether the strategy of owning a broad mix of asset classes will continue to impress? We pose the question because the recent past has witnessed an extraordinary rise in, well, everything. Starting in 2003, most of the broad asset classes have enjoyed gains for each and every calendar year. Yes, there have been some exceptions and a fair amount of variation within the asset classes. There are enough indices out there to prove (or disprove) whatever you want in money management. But by our reckoning, bull markets have more or less prevailed across the board for the past three years.
Such uniformity in positive performance is a rare spectacle and one that raises some disturbing issues. If everything goes up together, does it now follow that everything will also share in the losses when red ink inevitably returns?
At least we can count on cash as an asset class to deliver positive gains. Feeble returns, perhaps, and only when measured in nominal terms. But gains nonetheless. No wonder, then, that our asset allocation has increasingly been defined by a rising slice of cash and cash equivalents. It’s distressing to watch the other asset classes continue to fly while an ever larger share of the portfolio is anchored in cash. It’s tempting to jump on the hot bandwagon(s) of the moment. So what else is new?
Our emotions tell us otherwise, but our head continues to listen to Mr. Market’s signals. As a result, the longer the bull markets roll on in stocks, bonds, REITS and commodities, the more we move to cash.
No, we haven’t abandoned stocks, bonds, REITs, commodities, and their various subgroups. In fact, we never will. Owning some of each is an enduring strategy. The only questions are how much and when? Where in this troubled world can we find some conflict-free guidance?
Enter rebalancing. We’re of a mind to periodically rebalance, taking from the winning asset classes and redeploying to the losers. Ah, but wait a minute, you say. In fact, there are no losers; only winners. No matter, as that state of affairs brings us to Plan B: rebalance from the relative winners to the asset classes that haven’t won quite as much.
We do this not as some mindless exercise that we dreamed up in a vacuum. Rather, a careful reading of history suggests that rebalancing across a broadly diversified mix of asset classes will smooth the ride in the short run and deliver superior results in the long run compared to, say, everyone’s favorite benchmark, the S&P 500.
Granted, there are no guarantees. No matter how deeply you’ve modeled history, no matter how far back in history you peer, even enlightened investors suffer from the fact that stuff still happens. Indeed, ours is an imperfect world. Nonetheless, our only recourse is to embrace imperfect investment strategies, preferably those that are somewhat less imperfect than others.
In short, diversification remains our only friend. Sort of. Alas, our old buddy appears to be going off the deep end of late. Diversification may not be quite the defense mechanism it’s been in the past, although eventually its worth will prove itself. Or so we believe. In the short term, however, there’s reason to wonder how we’ll fare. No matter, since we’ve another pal who goes by the name of rebalancing.
Diversification and rebalancing, each in their own way, are powerful tools. But as recent history suggests, the two together may add up to more than the sum of their respective parts. Who of us, after all, can afford to have just one friend these days?