As many investors know, diversification across stocks and bonds did not work last year; a traditional 60/40 stock/bond mix was down in the range of 15% in 2022. Since the beginning of 2023, we have received several questions about diversification – such as, “Is diversification ‘dead’ because last year bonds did not provide protection against a falling stock market”? Some investors may be suffering from representativeness bias, where investors may extrapolate patterns based on a limited data set. Our view is that 2022 was an anomalous year. There were several forces that conspired to cause stocks and bonds to lose money in the same year – namely, high inflation coming off a period of exceptionally low inflation, an aggressive monetary policy response to said inflation, the invasion of Ukraine by Russia, and all of this coupled with the end of Covid-19 era. Is the diversification model therefore ‘dead’? In short, our answer is no.
Let us look at what happened last year in bonds in view of the traditional role bonds have played in a portfolio. High-quality fixed income is typically a stable asset class that is often used for its capital preservation attributes and typically provides stability when equity markets lose steam. When looking back at the last three bear markets prior to 2022, namely the bursting of the tech bubble in 2000 – 2001, the Great Financial Crisis of 2008-2009, and the Covid period of 2020, quality fixed income did what it is was supposed to do – protect capital during an equity market sell-off. In 2022, however, there was one crucial difference between then and the other periods: bond yields were at historic lows, and then, bang – the immediate rate hikes due to inflation. Some of you might be thinking beyond bonds…. what about other asset classes that should provide diversification? For example, gold has been a traditional diversifier. That did not work in 2022. Some had thought that cryptocurrency had replaced gold as an inflation fighter. Oops – that did not work either. The two asset classes that did work were private credit and energy. Private credit’s floating rate nature protected investors from rising interest rates and generated positive returns in 2022. Energy, on the contrary, had been a negative return asset class for most of the prior ten years, so why own it? Many investors did not have a distinct allocation to energy.
Our contention that diversification is not dead is as follows: bond yields have risen steeply across all types of fixed income. Some of you may recall the acronym TINA – there is no alternative (to equities) when rates were offering paltry yields. Now, that is no longer the case – bonds offer a real alternative to equities and rates are no longer at historic lows. In our view, focusing on one outlier year can divert attention from achieving long-term goals. Our advice is to stay with “tried and true” investment principles, including diversification. We also encourage investors to focus on factors within their control, such as spending, saving, and minimizing taxes where possible.
