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The Randomness of Asset Class Returns

Academic research has shown that there is little predictability in asset class performance from one year to the next. To illustrate this point, the chart below shows the historical performance of various asset classes from 1999 to 2013. The bottom portion of the chart shows annual performance by asset class, while the top portion ranks the annual returns from highest to lowest using the colors that correspond to each asset class. These data reveal no obvious pattern that can be exploited for excess profits. Almost every year, a different asset class rises to the top of the performance chart, while others sink to the bottom, thus strengthening the case for broad portfolio diversification.

In evaluating your annual returns, it is important to consider how your portfolio is weighted across various asset classes. Our approach to portfolio construction is derived from leading concepts in academic finance, such as Modern Portfolio Theory and the Fama-French three factor model. Based on these principles, we diversify our client portfolios broadly across US and international markets with some overweighting of small cap and value stocks. The intent is to maximize expected long-term returns relative to the level of risk in each portfolio, with the understanding that returns will vary annually depending on which asset classes perform well in a given year. In 2014, US large cap stocks had a banner year, while international stocks performed poorly. The S&P 500, which represents US large cap stocks, was up 13.7%, while the MSCI EAFE index, which represents developed international markets was down 4.5%. The global bond market was also weak, returning 0.6%.

The US financial media tends to focus inordinately on the S&P 500, despite the fact that it represents just one of many major asset classes within the global equity and fixed income markets, and is therefore not an appropriate benchmark for broadly diversified investment portfolios. Since our company was founded in 1999, our portfolio returns have beaten the S&P 500 in many years, and have lagged the index in a few other years, however, it is a somewhat irrelevant comparison since US large cap stocks comprise only a portion of our client portfolios. Furthermore, most of our client portfolios have a bond component which lowers portfolio risk relative to an all-stock index, such as the S&P 500.

Based on 2014 returns, we’ve had several clients ask about increasing the percentage of US large cap stocks in their portfolios, but this may not be the best strategy going forward. As shown in the chart on the reverse side, from 1999 to 2013, the best showing for US large cap stocks was fourth place in 2011 and 2013. Furthermore, US large cap stocks landed in the lower half of returns among major asset classes for all but three years during this time period.

The take home message is that every asset class has its day in the sun. 2014 was a good year for US large cap stocks, and hence, the S&P 500. Which asset class will shine in 2015? Unfortunately, there is little evidence that anyone can make this predication in a reliable manner. Chasing returns by buying last year’s asset class winner is often an inferior strategy that can lead to buying high and selling low.

At Shearwater Capital, we have a deeply ingrained commitment to keep your best interests as our first priority. This involves taking a long-term investment perspective, employing a broadly diversified asset allocation strategy, and having the discipline to stick to it despite the inevitable ups and downs of various asset classes.

As always, please feel free to contact me with any questions or comments.

Jeffrey J. Brown, MD CFA

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