Is diversification dead?

In one word, no.

But, hey, wait a minute, I can hear folks saying…I own a broad mix of stocks and bonds and I lost money in 2022; ergo, diversification seems to no longer work. And, that is a completely understandable feeling/interpretation; albeit (potentially) a little premature I offer. Why? Because one data point does not a trend make and, rationally, as investors, we must expect to lose sometimes on the risks we take (the operative word here being “sometimes,” hopefully). Additionally, the following two thought points might help reestablish your recently shaken belief in diversification.

Firstly, noting the image above from Morningstar (article link here), in the last 23 years, stocks and bonds have not simultaneously suffered such carnage. In furtherance of this point, Vanguard reported in a 01Jul2022 article that stocks and bonds have never both reported losses over a 3-year period since 1976 and that a 60/40 portfolio has been negative only 6.5% of the time over 3 years since 1976. So, statistically speaking, 2022 is a bit of an aberration. Stated another way, typically, bonds have provided ballast to your portfolio when stocks have lost value. Although, clearly, a positive correlation does exist between stocks and bonds per the above image because both experienced positive returns the majority of times since 2000 (despite the Fed’s Put effect upon stock/bond correlations since the late 1990s).

So, why didn’t bonds protect us in 2022 as the image above shows? Answer: fast-moving, 40-year high inflation that the Fed may have downplayed, and a federal funds rate starting at 0.25% on the high end. With inflation falling from its June 2022 YoY high of 9% and signs that the Fed will ease up on rate increases in 2023 because of a cooling economy, this background seems to set the stage for better future years for bonds. The Fed just needs wage inflation data to cooperate a little more now to further support a bond rally.

Secondly, why might diversification still work? The fact that the rates on intermediate core bond funds are now starting to exceed 4% as of 27Jan2023 (versus 2-3% for the last decade) seems to give a nod towards diversification still working. Notably, the largest indicator of a bond’s future performance over the next 10 years is its starting rate of return. With replacement yields now exceeding 4% for maturing bonds in your intermediate-term core bond portfolio, bond portfolios will have a little more cushion should a bond market downturn transpire again (and it will, eventually). Stated another way, current bond prices that are more fairly valued and higher starting rates (i.e., 4+%) should improve your bond portfolio’s performance over the next decade.

Certainly, there are more factors to consider than just these two. That being said, these two thought points should help nudge you back toward the pro-diversification corner. A good place to still be (IMHO)!

If you have questions about your retirement plan, your investment portfolio, or your financial future, please feel free to contact Intelligent Investing at www.mynmfp.com/new-clients for a no-obligation consultation. At Intelligent Investing, we believe in a consistent and disciplined, long-term investing approach.