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Over the past couple of years, I’ve written several posts that explained why U.S. market indices are not the best ways to measure your portfolio. Although it’s natural to look at the Dow, for example, and see how it matches up with your own portfolio, it really isn’t a good comparison.
As U.S. markets continue to rally even as interest rates rise, this issue is becoming more apparent. When you get your brokerage statement, you simply won’t see the returns you think you might, assuming you have a diversified portfolio.
Why don't my returns look better?
Let’s consider a simple diversified portfolio, one with 60-percent stocks and 40-percent bonds. This is often used as shorthand for a typical investor’s holdings, and it provides a useful benchmark. We’ll take a look at each piece and then the portfolio as a whole. (All data is from Morningstar.)
- Stocks: In this kind of situation, the S&P 500 is a good proxy for the market as a whole. There are various exchange-traded products that track the index, and based on one of these, the returns for November were 3.70 percent, which reflects the strong market bounce after the election.
- Bonds: With the Bloomberg Barclays U.S. Aggregate Bond Index as a proxy for the bond market as a whole, I again used an exchange-traded product to estimate returns, which were –2.37 percent for November. When interest rates increase, the value of bonds drops, so the rise in rates after the election hit the values of the bonds in that index.
- Portfolio: The aggregate return of a 60/40 portfolio was around 1.27 percent, which is a good monthly gain—but a whole lot less than that of the U.S. stock market. When you open your portfolio statement, this is the kind of cognitive dissonance that can lead you to wonder what the heck is going on.
Keep in mind, though, that other months have been less favorable for stocks and better for bonds. You don’t have to go back all that far to find times when you would have been very happy to own bonds. In January 2016, for example, we saw stocks drop by 4.97 percent while bonds were up by 1.38 percent. In August 2015, we saw stocks drop by 6.02 percent while bonds only dropped by 0.14 percent. Diversification helps in the bad months, even if it hurts in the good months.
That, actually, is the point: diversification should help you make less in the good times but keep more in the bad times.
Why we diversify
As I look back at the past five years, I realize that it has been a really, really good time for U.S. stocks. There have only been a couple of seriously down months. We know, however, that that’s not always the case. (Remember 2008–2009?) A diversified portfolio proves its value in tough times, but when times are good—and have been for years—that can be difficult to keep in mind.
This past month is only the most recent example of a time when U.S. markets seem to be unstoppable, and being out of stocks seems like a mistake. This is true and has been for some time, and it will continue to be true until it isn’t any more. At that point, as we saw in 2008, we will remember exactly why we diversify in the first place. If we forgot that lesson, relearning it could be extremely painful.
In the end, it’s not what you make, it’s what you keep. Diversification is designed to help with the latter in the long term and the potential cost of the former in the short term. Keep that in mind when you open your portfolio statement.
For illustrative purposes only. No specific investments were used in this example. Actual results will vary.
The Bloomberg Barclays U.S. Aggregate Bond Index covers the dollar-denominated investment-grade fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS passthrough securities, asset-backed securities, and commercial mortgage-based securities. These major sectors are subdivided into more specific subindices that are calculated and published on an ongoing basis.
