The Randomness of Returns and What You Should Do About It

May 26, 2014

by Cathy Pareto, MBA, CFP® – May 2014

Investors need portfolios that reflect their different financial goals, time horizons, and risk preferences. Although there is no “perfect” portfolio, many investors will find that a sensible approach incorporates diversification across multiple sources of risk and return.

How is this accomplished? Portfolio diversification is attained by investing across various global asset classes. Although asset classes around the world do not behave consistently or predictably, combining them in diversified balanced strategies can eliminate much of this randomness.

This example features annual performance of major asset classes in the US, international, and emerging markets over a fifteen-year period.

As the historical returns indicate in the above chart, In both US and non-US markets, there is little predictability in asset class performance from one year to the next. Studying the annual data in the chart reveals no obvious pattern in returns that can be exploited for excess profits, strengthening the case for broad diversification across many asset classes.

Some investors mistakenly believe that attempting to time the markets or trying to guess which stock, fund or asset class will be this year’s “winner” is the best approach to investing. However, the reality is that this is an exercise in futility. In actuality, trying to anticipate the movement of the market adds anxiety and undue risk.

Asset class returns vary considerably from year to year, and past returns offer little insight into future performance.You never know which markets will outperform in a given year. Therefore, by holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur.

The global equity market is large and represents a world of investment opportunity.

Diversification helps take the guesswork out of investing. In short, why not simply own everything?

Thanks to Dimensional Fund Advisors for the data.