February 11, 2019
Chris Haverland, CFA, Global Asset Allocation Strategist
Veronica Willis, Investment Strategy Analyst
Drawdowns, Recoveries, and Diversification
- Heightened market volatility contributed to poor asset class performance in 2018, but year-to-date, most asset classes have already recouped some of those losses.
- Financial markets can be extremely volatile on a short-term basis—like in 2018—but a diversified allocation may help minimize volatility, provide the potential for reduced downside participation, and may allow for a quicker recovery time after a correction or bear market.
What it May Mean for Investors
- A diversified portfolio has the potential to provide more consistent returns through lower volatility. We believe the best investment approach is to set a strategic asset allocation that represents your goals, risk tolerance, and time horizon—while also rebalancing back to those strategic targets on a regular basis.
In 2018, investors experienced heightened financial market volatility (including two stock market corrections) that led to some of the worst investment returns in a decade. Nearly every asset class was lower for the year with cash being one of only a few categories with positive returns. What a difference one month can make. After bottoming on Christmas Eve, U.S.-based stocks have surged higher with large-cap, mid-cap, and small-cap indices up double-digits through the end of January. Nothing fundamentally has changed in the past month; however, progress on trade talks, a seemingly less aggressive Federal Reserve, and corporate earnings that are not as bad as feared may have prompted investors to take advantage of oversold conditions.
As investors review year-end statements, it’s important to keep in mind that volatility can work both ways. In 2017 equities posted significant gains well above historical averages—and most analysts’ expectations. This was followed by a down year in 2018 that seemed unusually painful during what has been a booming, decade-long bull market. Despite the weakness in 2018, the S&P 500 Index’s1 average annualized total return over the two-year timeframe was 7.9%—close to our long-term expectations. Meanwhile, in January 2019, the equity markets have clawed back a sizable chunk of the 2018 losses. Will this meteoric rise continue for the rest of the year? It’s unlikely, in our opinion. However, we do expect the economy and earnings to continue to grow (albeit at a slower pace), which should support further upside in stock prices.
Financial markets can be extremely volatile on a short-term basis, and some investors may be unable to tolerate sizable drawdowns in their portfolios. One way to participate in the financial markets, while potentially reducing wild swings in investment portfolios, is through asset allocation. Having exposure to a diversified mix of asset classes that don’t always move in the same direction has historically helped reduce downside participation. It also has allowed for shorter recovery times, meaning it doesn’t take as long to get back to the previous peak after markets fall. Chart 1 highlights periods throughout the past forty years when the S&P 500 Index has entered a correction or bear market territory. The chart also shows how a diversified allocation generally has not experienced losses as sharply as an all-equity position during equity market drawdowns.
Attempting to reduce downside volatility is critical to long-term performance, as it may allow a portfolio to recover much more quickly after a negative market event. Using the same corrective periods from the chart above, we examined how long it took to recover to the prior peak. Table 1 shows that, on average, a diversified allocation recovered faster than the S&P 500 Index after corrections and bear markets.
Because each asset class has unique risk, return, and correlation characteristics, a diversified portfolio has the potential to provide more consistent returns through lower volatility. Attempting to smooth the ride for investors is important, as it can reduce the temptation to abandon a diversified portfolio when one asset class has outperformed or underperformed during a given time period. Although downside events are typically short-lived, how you react (or don’t react) is extremely important in meeting long-term financial goals. For example, by remaining invested during the market drop only, and then selling just before a recovery, portfolios are more likely to miss out on subsequent gains. Instead of attempting to time these events, we believe the best investment approach is to set a strategic asset allocation that represents your investment goals, risk tolerance, and time horizon—while also rebalancing back to those strategic targets on a regular basis. These actions may assist in reducing downside risk and may help your portfolio recover more quickly after negative, market-moving events.