Diversifying a portfolio through the global allocation of various asset classes increases expected return and reduces portfolio volatility over time.  Both worthwhile goals.  But like eating well and exercising to stay healthy, global asset allocation doesn’t happen without a little suffering.

In 2014, investors with one eye on their globally diversified portfolio and the other on large U.S. stocks and U.S. REITS definitely felt the pain.  The Balanced Global Portfolio[1]   significantly underperformed U.S. large cap stocks and U.S. REITS, dragged down by negative returns in non-U.S. Developed and Emerging Market stocks.

 

2014 Return Data for Major Asset Classes

Index2014 Return  
Dow Jones US Select REIT Index32.0%
Barclays Treasury Bond Index Long25.1%
S&P 500 Index13.7%
S&P Global ex US REIT Index (gross div.)11.9%
Balanced Global Portfolio7.6%
Barclays US TIPS Index3.6%
Barclays US Treasury Bond Index Intermediate2.6%
BofA Merrill Lynch 1-Year US Treasury Note Index0.2%
MSCI Emerging Markets Index (gross div.)-1.8%
MSCI EAFE Index (gross div.)-4.5%

The S&P data are provided by Standard & Poor’s Index Services Group. MSCI data copyright MSCI 2013, all rights reserved. The BofA Merrill Lynch Indices are used with permission; copyright 2013 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Merrill Lynch, Pierce, Fenner & Smith Incorporated is a wholly owned subsidiary of Bank of America Corporation. Barclays Capital data provided by Barclays Bank PLC. Dow Jones data provided by Dow Jones Indexes

 

The pain felt by U.S.- based global investors is referred to as “Frame of Reference risk”, the risk taken on by investors that the pattern of returns generated by their balanced global asset allocation portfolio causes painful feelings of regret.  They may feel that they missed out on a great year in “The Market”, otherwise known as large capitalization U.S. equities. They may also sense that their globally diversified asset class portfolio deprived them of going “all in” on the best recently performing asset class (U.S. REITS in 2014).  Investors may take these emotions, coupled with recent return data, as evidence that global asset allocation is generally a bad idea or that a better alternative is to simply invest in the asset class that will perform the best in any given year.

 

Balanced Global Portfolio vs. “The Hot Asset Class”

If one were looking at the performance of U.S. REITS in 2014 with envy and thinking that if only they or their advisor had guided them to move all their assets into U.S. REITS at the beginning of 2014, they might consider looking at the following chart and consider its implications.  Over the last ten years, only one asset class (Emerging Market Equity) has been the best performer as many as three times.  Emerging Market Equity was also the worst performing asset class twice over the last ten years.

 

Annual Returns for Major Asset Classes (2005-2014)

chart 777

The S&P data are provided by Standard & Poor’s Index Services Group. MSCI data copyright MSCI 2013, all rights reserved. The BofA Merrill Lynch Indices are used with permission; copyright 2013 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Merrill Lynch, Pierce, Fenner & Smith Incorporated is a wholly owned subsidiary of Bank of America Corporation. Barclays Capital data provided by Barclays Bank PLC. Dow Jones data provided by Dow Jones Indexes

 

The chart demonstrates how unpredictable asset class returns are from year to year.  A summary of the past ten years of major asset class returns reveals the futility of trying to position investment portfolios based on predictions about which asset class will perform the best.

 

Best and Worst Performing Asset Classes (Number of Times since 2005)

 US REITTreasury- LongS&P 500Ex. US REITGlobal PortfolioUS TIPSTreasury - IntermTreasury - ShortEmg Mkt EquityIntl Dev. Equity
Best Performer2212000030
Second Best1101021022
Second Worst0102013111
Worst Performer1200011221

The S&P data are provided by Standard & Poor’s Index Services Group. MSCI data copyright MSCI 2013, all rights reserved. The BofA Merrill Lynch Indices are used with permission; copyright 2013 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Merrill Lynch, Pierce, Fenner & Smith Incorporated is a wholly owned subsidiary of Bank of America Corporation. Barclays Capital data provided by Barclays Bank PLC. Dow Jones data provided by Dow Jones Indexes

 

Global asset class portfolios enable investors to diversify their risk through exposure to all the major world asset classes. This strategy allows investors to minimize exposure to the worst performing asset class in any year but also introduces “Frame of Reference” risk.  Accepting this risk (and the pain that occasionally comes with it) is an important component of becoming a successful investor. Just like eating well and exercising are important components of a healthy life.

 

[1] The Balanced Global Portfolio is a 60/40 portfolio consisting of 25% U.S. Large Stocks (S&P 500), 12% U.S. Small Stocks (S&P Small Cap 600), 12% Intl. Developed Stocks (EAFE), 6% Emerging Market Stocks (MSCI Emerging Mkt Index), 2.5% U.S. REIT (Dow Jones U.S. Select REIT Index), 2.5% Ex. U.S. REIT (S&P Developed Ex. US REIT), 10% Short-Term Treasury (BofA Merrill Lynch 1-Year US Treasury Index), 10% Intermediate-Term Treasury (Barclays U.S. Treasury Bond Index Intermediate), 10% Long-Term Treasury (Barclays U.S. Treasury Bond Index Long), 10% U.S. TIPS (Barclays U.S. TIPS Index)