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Yes, almost everything is down this year, but diversification is still your friend.

Never a dull moment. Already this year, we had a severe selloff spurred by inflation and the resulting interest-rate hikes, and now we’re having a big rebound. Who knows what’s next? Growth stocks are down 21% for the year, but they had been down more than 30%. Most other areas are doing better than that but are still in the red.

Diversification worked beautifully in the 2000-02 bear market as value generally held up and bonds did quite well. And in 2020, growth stocks held up fairly well, as did most bonds.

But in 2008-09 and in 2022, bonds, stocks, and nearly everything else went down. Vanguard Balanced Index (VBIAX) is a good proxy for your typical 60/40 portfolio, and it’s down 12% for the year. (See John Rekenthaler’s take on the 60/40 portfolio for more thoughts on the subject.) Bonds are down about 9% this year. That’s still useful diversification but obviously not as good as the times when bonds got you a positive return to diminish losses.

Both stocks and bonds are getting hurt by surging inflation and the interest-rate hikes aimed at curbing inflation. In other bear markets, the issue is a recession, and recessions are good for reducing inflation and rates so that high-quality bonds are in the green.

I thought I’d take a step back and look at the big picture on diversification, with the help of a color-coded table of calendar-year returns by asset class. Each asset class has a different color so that you can see how they bounce around.

You can see that blue equities are often at the top, although the different types take turns at the top, and the orange bond groups tend to be in the middle. Yet, year on year, there’s tremendous variation. Bonds took the top spot in three of the past 15 calendar years, and emerging-markets stocks took the top spot four times. That yellow asset class spent a lot of time at the bottom, and it shows why commodities are so hard to hold on to. You can see why someone would have given up on them, but then, wow, they jumped up in 2021 and 2022, finally providing the good kind of diversification that investors hoped for.

T

he table doesn’t break down value and growth, but it’s really stark how different the two camps’ returns are from year to year. If you simply saw annual returns or return graphs of value and growth, you’d likely assume that they were completely different asset classes rather than neighbors in the Morningstar Style Box. Value is rapidly making up the ground it lost to growth over most of the past years.

Looking at the annual returns table gives you a sense of how hard it would be to predict each year’s winners when they are so volatile. Diversification is clearly the reasonable response. But the commodities case also shows why investments of that nature should be a small but consistent position, somewhere like 5% or less. They diversify, but you have to endure a lot of losses. Diversification doesn’t mean you put equal amounts in every bucket.

The table doesn’t include short-term bonds, but they would be modestly sized diversifiers that are far more consistent than commodities. Short-term bonds rarely lose money, but in down markets like this one, they are a welcome guard against losses, as well as a handy place to invest for short-term needs and emergency funds. Alternative funds are supposed to be just like short-term bond funds only with higher returns. Alas, higher fees have been the only depend­able element of alternative funds. The humble old short-term bond fund is appealing, cheap, and consistent, even if it doesn’t sound as cool as an alt fund.

Don’t miss out on the Goldilocks of the table. On the left you see the blue-gray international-stock box in third place in 2007 with a 12.7% return. It doesn’t once make the top slot, though it did grab last in 2018. But for the most part, international stocks bounce around the middle. One reason is that they have foreign-currency exposure as well as foreign-equity exposure. To finish first, both foreign equities and foreign currencies must click, and to finish last, they both have to suffer. But foreign stocks provide valuable diversification and good returns, though they generally move in the same direction as U.S. equities.

Likewise, intermediate bonds sit at the heart of the bond market and tend to be steady performers, though 2022 has been a sad exception to that rule. Higher-quality intermediate bonds are less correlated with equities than lower-quality bonds, so a sensible plan would include both.

The Market Environment

Another way to look at this table is to see it as a self-correcting environment. If one investment type has a long run of strong returns and another area has had poor returns, they may well flip places over the next few years. The market overdoes rallies and selloffs in the short run, but it corrects for that eventually.

Rebalancing is a simple way to put that cyclical force to work for your benefit. It helps you to buy low and sell high without attempting any market forecasts on your own. Many 401(k)s let you set up automatic rebalancing on a yearly basis to keep your portfolio from getting out of whack.

So, how long does the typical bear market last? Market historians say the average is nine months. In recent history, we had a two-and-a-half-year bear market, a one-and-a-half-year bear market, and a three-month bear market. Nearly every time, selling went way beyond where most people thought it would because bad news and selling have a momentum of their own. From a psychological angle, the specter of inflation isn’t as scary as a financial meltdown or a pandemic. But it’s worth remembering how the bear market got much worse in even after two years of grinding lower.

Every day on Twitter you’ll see a debate about whether this is a bear-market rally or something that will last.

Another bit of market history to remember is that when inflation was stubbornly high in the 1970s, commodities were about the only good investment, though those who did buy equities were rewarded handsomely in the ensuing decades—provided that they didn’t give up.

Small Stocks

T. Rowe Price QM US Small-Cap Growth Equity (PRDSX) is my conservative choice. The quant fund, which earns a Morningstar Analyst Rating of Gold, has a very diffuse portfolio that helps moderate the risk of one or two top names blowing up. Also, it has a wide valuation range, which makes it less risky than some of the aggressive momentum funds in the small-growth Morningstar Category. Sudhir Nanda has shaped this fund into a consistent performer with modest fees.

Compared with other small-blend funds, Fidelity Small Cap Discovery (FSCRX) has low costs and low valuations. Derek Janssen has stayed true to his value discipline even when value looked awful in 2020. This Silver-rated fund has been riskier than peers because of that value bent, but that’s part of its appeal.

Large Stocks

Vanguard Total Stock Market Index (VTSAX) isn’t less volatile than other large-blend funds, but it is a conservative choice when it comes to costs and diversification. Buying this fund means you have very low costs—something that helps in all market environments. Also, it avoids any kind of sector bets. To me, that’s conservative.

As for aggressive, Harbor Capital Appreciation (HACAX) is a classic growth fund with exposure to many of the technology and healthcare giants. The team at Jennison running this fund is very good at buying the best of the big names. The down­side is right there to see this year as buying great tech and healthcare means taking on a fair amount of price risk, and the market has crushed those stocks this year.

International Developed Stocks

Because this is about diversification, I chose two funds that have rather low correlations with the broad foreign market indexes. In the high-risk camp is Gold-rated Causeway International Value (CIVVX). Sarah Ketterer and Harry Hartford are disciplined value investors who are willing to have country and sector allocations that diverge from those of the benchmark. That’s why the correlation is low and the risk is high. But it ought to be rewarding over the long haul.

Goldman Sachs GQG Partners International Opportunities (GSIHX) is my low-risk choice. Rajiv Jain started a new firm a few years ago, and he’s been just as successful at GQG as his earlier firm. Jain seeks durable companies with low debt and a strong market position. It makes the fund pretty resilient in down­turns, including the current one.

Emerging-Markets Stocks

American Funds New World (NEWFX) is a nice emerging-markets fund for chickens. The fund looks for companies that do a lot of business in emerging markets rather than those simply selling on emerging markets stock exchanges. It’s a sensible idea that generally leads to less volatility than most emerging-markets strategies. 

Silver-rated Harding Loevner Emerging Markets (HLEMX) is my aggressive pick. It looks for quality growth. Usually that means less risk, but sector and regional bets are still quite aggressive. At the moment, the fund is being burned by that aggression, but there’s a lot to like about its prospects.

Commodities

Conservative commodities funds don’t exist. The key is to limit them to a small part of your portfolio. Pimco Commodity Real Return Strategy (PCRAX) is rated Bronze for its appealing mix of commodities exposure and Treasury Inflation-Protected Securities. As the table illustrates, commodities have wild swings. The value is that the upswing comes when inflation spikes and many other investment types are likely to be in the red.

Original Article – Morningstar

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