2013 in Review...A Case for Asset Allocation

As we look back at 2013 and how individual asset classes as well as sub asset classes performed, we see a strong case for maintaining a longer term asset allocation strategy. The timing of the short term direction within financial markets has not been a strategy that has produced healthy long term success when applied as a sole approach to one’s retirement plan. It has been noted in the past that approximately 60% of active equity mutual funds managers consistently fail to outperform their corresponding benchmarks. When applying an overall market timing approach to a financial plan, the results can be catastrophic with just one singular mistake. As such, a more strategic asset allocation across asset classes to lower portfolio volatility would be prudent. This is particularly important for an investor who is actively drawing income, or will soon begin to do so from their investment portfolio. A sound strategic asset allocation allows for the constant use of all asset classes and their sub asset classes in accordance with an individual risk level. In 2013 we saw a wide dispersion of performance across asset classes. Below are annual indexed based returns through December 31st, 2013, along with their ten year average returns.

In many ways the preceding data reflects a healthy return to more normalized conditions in which investment classes are not as highly correlated as they had been on more recent years. The data reflects that 7 of the 14 listed areas of investment produced returns lower than their preceding 10 year average. While simultaneously 7 of them produced returns in excess of the ten year average. In addition, 6 of the stated areas of investment produced returns over the last decade that were below the previous decade, while the other 8 areas produced 10 year returns in excess of the prior decade.

During the financial crisis as well as the immediate aftermath we saw a great deal of policy intervention by the Federal Gov’t, particularly in the area of monetary policy. The effectiveness and necessity of many of these policies may continue to be debated for some time. Yet what seems to be clear is that the correlation of asset classes increased dramatically during this period due to external governmental forces influencing the price direction of all asset classes more than they traditionally have. The increased correlation made volatility more difficult to manage, and demonstrated the importance of alternative asset classes as mechanism to lower this volatility.

In 2013 as the Fed discussed and eventually began to slightly slow its quantitative easing program, the correlation between equities and fixed income began to break down. We also began to see a return to normal in other asset classes, and sub-classes. Assets like REIT’s and commodities have traditionally had a much lower correlation to the S&P 500 index prior to the 2008 crisis. Yet as this crisis evolved, we began to see increased correlations in these areas as well. In 2013, while US stocks soared, these assets demonstrated modest to slightly negative returns. While it’s always nice to look back at historical data points and suggest you may have been better off just buying the highest performing asset class…that is highly impractical. Since assets can be highly cyclical from year to year and decade to decade, it is imperative to have a degree of exposure to all of them. This approach reduces the overall volatility, and allows an investor to capture the majority of the longer term upside return. Although we would ideally never like to see an asset decline in value, the fact that these asset classes did not move in lockstep is an inherently good sign. If such conditions were to continue, the ability to manage volatility in a portfolio would improve greatly without the need to sacrifice much in the way of returns.

It should always be presumed that when various other non-traditional asset classes are utilized as a means to minimize volatility, that a portfolio will underperform benchmarks during strong stock market rallies. Historically such vehicles begin to demonstrate their importance in the midst of major downturns, as well as relatively flat years for equity market performance. Unfortunately for many investors, the most expensive time to purchase a hedge against volatility is after it has already been needed. And the decision not to implement such a strategy comes at a great cost in the future.

What’s important to note is that the decline in correlations should be regarded as a positive if this continues over the longer term. While we may all form opinions about which asset class will likely lead the way in 2014 as well and the coming years, it is never prudent to structure an investment portfolio with a large concentration in any asset class based on such predictions. History has shown us that asset classes are highly cyclical, and financial markets have a very good habit of producing short term results that the smallest number of people expect to be likely. In the financial planning process, the management of risk is a key component to achieving an individuals stated financial goals. The preceding year, as well as the last decade demonstrated one of the strongest cases for a well balanced portfolio across all asset classes.