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A century of diversification – was it worth it?

10 June 2024

Nikola Vasiljevic, Head of Quantitative Strategy, Zurich, Switzerland; Lukas Gehrig, Quantitative Strategist, Zurich, Switzerland

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

  • Inflation has recently roared back to life. But, many investors tend to focus on returns without adjusting for the impact of inflation. Beware. Over the last century, price rises have averaged around 2.9% a year. 
  • That said,  the impact of inflation on investments since 1923 has been different. The average real return on Treasury bills was barely positive. By contrast, Treasury bonds real growth was 3.5 times faster and corporate bonds almost 30 times quicker. Stocks, however, outpaced Treasury bills by an astronomical 788 times.
  • Through the Roaring Twenties, Great Depression, global conflicts and pandemics, our analysis shows that diversification significantly cuts portfolio risk, whether over a one-year, ten-year or longer period.
  • One thing is sure for long-term investors. A well-diversified, smarty crafted portfolio can help them to reach their goal while resting easier at night.

Since 2020’s COVID-19 pandemic, an initial period of economic slowdown, as well as soaring inflation and aggressive interest rate hikes, have all been replaced by a retreat in inflation and strong earnings growth, fuelled by artificial intelligence fever that has powered US equities higher. 

Amid elevated uncertainty and diverging global signals, many investors now focus primarily on short-term macroeconomic data, geopolitical events and monetary policy. How wise is this approach?

Zooming out one hundred years

Making sound long-term investment decisions is not simple. It requires understanding trends and the relationships between different asset classes, and their sensitivity to macroeconomic factors, over the desired investment horizon.

While history might not repeat itself, this article looks at what a century of returns in US equity and bond markets can teach investors.

A century of fears and hopes

Since the Roaring Twenties, investors have been hit by the impact of numerous wars, market crashes, seismic geopolitical shifts, economic upheaval and pandemics. However, through the gloom, the world has seen groundbreaking technological advancements and explosive growth.

So, what has the effect of the above turmoil had on the performance and risk of financial markets? Our analysis, which covers the last century1 in nominal terms, shows that the annualised cumulative total returns over the full sample were 3.3% for Treasury bills, 4.6% for Treasury bonds, 6.8% for US corporate bonds and 10.4% for American stocks. This hierarchy of average returns is consistent across shorter investment horizons and aligns with the market risk of each asset class, measured by annual-return volatility (approximately 3%, 8%, 8% and 19%, respectively).

Staying invested over this hundred-year period, which is admittedly a challenging concept for many investors, would have seen an excess annualised return over cash of about 7%. This is unsurprising, as stocks are the key driver in long-term wealth creation. The flipside is that in doing so, investors are exposed to both volatility and potential intermittent losses.

The spectre of wealth erosion

When investing over shorter periods of time, many people view money in nominal rather than real terms, ignoring the corrosive effects of inflation on portfolio returns. Given that price rises can reduce the buying power of their wealth, investors should consider how much cash is not being deployed, especially over the long term (see chart).

A century of real growth

The inflation-adjusted performance for US Treasury bills, Treasury bonds, corporate bonds stocks and a hypothetical 50/50 asset mix between equities and fixed income (30% of the entire portfolio invested in Treasuries, 15% in corporate bonds and 5% in Treasury bills). The full sample comprises total return from 1924 to 2023. All time series are rebased at 100 at the end of 1923.

Sources: Federal Reserve Economic Data at St Louis Fed, US Bureau of Economic Analysis, the websites of Prof. Robert Shiller (Yale University) and Prof. Aswath Damodaran (New York University), Barclays Private Bank, May 2024

The dangers of focusing on nominal performance are clear when discovering that the inflation rate has averaged about 2.9% since 1923. The average real return on Treasury bills was barely positive, offering minimal real wealth growth. In contrast, Treasury bonds’ real growth was 3.5 times faster and corporate bonds’ growth was almost 30 times quicker. Stocks, however, outpaced Treasury bills by an astronomical 788 times, roughly equivalent to the number of planet Earths that could fit inside Saturn.

Composure is rewarded by a risk twist

When taking a comprehensive view of temporal and cross-asset investment aspects, two crucial elements emerge:

First, investors typically do not consider investments over a century, so let’s focus on more plausible horizons, ranging from one to twenty years. Second, asset classes behave differently over short-term (one-year) versus long-term (ten- or twenty-year) periods ( see chart). 

A century of variation in total real returns

The dispersion of annualised total real returns for US Treasury bills, Treasury bonds, corporate bonds, stocks and a hypothetical 50/50 asset mix between equities and fixed income (30% of the entire portfolio is allocated to Treasury bonds, 15% to corporate bonds, and 5% to Treasury bills) for holding periods from one to twenty years. The bottom (top) of each bar shows the minimum (maximum) annualised total real return for a given asset class and investment horizon, observed over a period from 1924 to 2023

Sources: Federal Reserve Economic Data at St. Louis Fed, US Bureau of Economic Analysis, the websites of Prof. Robert Shiller (Yale University) and Prof. Aswath Damodaran (New York University), Barclays Private Bank, May 2024

We now explore the range of annualised cumulative total real returns for the four mentioned asset classes over one, five, ten and twenty years. Additionally, a simple 50/50 portfolio comprising 50% stocks and 50% fixed income is included in the analysis. 

To mimic real-world portfolios, 30% of the entire portfolio is allocated to Treasury bonds, 15% to corporate bonds and 5% to Treasury bills.

Over a one-year investment horizon, stocks displayed the largest dispersion in real returns. The maximum upside and downside swings for corporate bonds were reduced by approximately one quarter compared to stocks. Both stocks and corporate bonds posted positive real returns about 75% of the time. Surprisingly, the real returns for Treasury bills and bonds, despite their lower volatility, were positive only 55% and 61% of the time, respectively.

Moving to five- and ten-year horizons, the extremes are compressed. While the percentage of positive real returns remains steady for Treasury bills and bonds, it increases to 85% for both stocks and corporate bonds. 

Finally, stocks delivered positive real returns in all twenty-year periods from 1924 to 2023. Corporate bonds closely followed, with the success ratio of 93%, while only two-thirds of inflation-adjusted outcomes were favourable for Treasury bills and bonds. 

The ordering of the extreme positive outcomes among asset classes aligns with the established full-sample hierarchy. However, the rankings of the largest negative real returns are reversed. Strangely, if risk is defined as the worst inflation-adjusted outcome over a certain period, Treasury bills were the riskiest asset class over a twenty-year investment horizon.

Last but not least, a hypothetical 50/50 portfolio showed similar real return dispersion to US Treasury bonds and corporate bonds over one- and five-year horizons, while aligning more closely with stocks over longer investment horizons.

Diversification or “diworsification”?

The above analysis indicates that diversification significantly reduces portfolio risk by drawing on the strengths of both fixed income and equity worlds. Furthermore, it does so efficiently across various holding periods.

While managing overall portfolio risk is important, the risk of heavy losses from exceptional events (often known as tail risk) is arguably the most critical. For many investors, it can be difficult to remain calm in times of market crashes, whether in equity or bond markets.

Two key questions arise. Does cross-asset diversification remain effective during market meltdowns, or do the assumed benefits vanish when they are needed the most, leading to the phenomenon known as “diworsification”? And if diversification offers protection, is it truly a ‘free lunch’?

In the chart, each solid line represents a different holding period, and shows the trade-off between tail-risk hedging benefits and performance costs for different asset allocation mixes between equities and fixed income. Irrespective of the overall fixed income weight in the portfolio, 60% of the fixed income segment is allocated to US Treasury bonds, 30% to US corporate bonds and 10% to US Treasury bills. Selected portfolio mixes are highlighted on each line. 

The identical portfolio mixes for different holding periods are connected by dotted black lines. The dashed red line separates the region in which diversification benefits outweigh costs (shaded green area) from the region where the opposite holds (shaded red area). 

The portfolio allocated 100% in US stocks is marked by a black square, and is associated with zero benefits and cost due to the lack of diversification in fixed income (it represents a benchmark for measurement of diversification effects).

A centenary case for diversification

The trade-off between diversification benefits and costs of adding fixed income to equities in a portfolio over investment horizons ranging from one to twenty years 

Sources: Federal Reserve Economic Data at St. Louis Fed, US Bureau of Economic Analysis, the websites of Prof. Robert Shiller (Yale University) and Prof. Aswath Damodaran (New York University), Barclays Private Bank, May 2024

Is diversification a free lunch?

To address the free-lunch question, let’s look at the trade-off between diversification benefits and costs of adding fixed income to equities in a portfolio over investment horizons ranging from one to twenty years. The tail-risk hedging potential and modelled diversification benefits are calculated based on the average percentage of wealth preserved in the ten worst equity market outcomes. Diversification costs are measured as the average historical annualised performance drag, or the opportunity cost of not being 100% invested in stocks.

Our results (see last chart) indicate that, regardless of the share of fixed income in the portfolio, both diversification benefits and costs steadily drop with the holding period (except for the twenty-year horizon, where there is a marginal uptick in diversification costs). Importantly, benefits erode more quickly, resulting in an inverse relationship between the benefit-cost ratio and the holding period.

Overall, the average diversification benefit-cost ratio is favourable for holding periods up to ten years. For the longest considered horizon, investors would have been better off sticking with equities only. Finally, for any holding period, the marginal utility of increasing the percentage of fixed income in a portfolio regularly decreases, and at an accelerating rate.

These results corroborate the adage that investors should avoid putting all of their eggs in one basket. The last century’s data suggests that diversification is alive and well, whether over tactical (up to one year) and strategic (up to ten years) horizons.

A word of caution. Despite the above finding, when many investors rush to exit their positions simultaneously – typically seen during a market sell-off – price swings and potential losses can be exacerbated. Moreover, the heightened risk and uncertainty may scare them off from re-investing in equities and profiting from the market recovery.

Diversifying between equities and fixed income investments not only aids portfolio risk management, but helps investors to remain invested during adverse market shocks. 

Four shades of diversification

It is important to stress that our findings hold on average, and cannot be guaranteed in every situation. Correlations can change rapidly with unexpected consequences. Macroeconomic regimes, secular trends and exogenous shocks (such as geopolitical flare ups, natural disasters and pandemics) have often jolted risk premia over the last century. Sometimes, such shifts persisted for many years, as has been seen since the global financial crisis (GFC) of 2007-09.

We illustrate these dynamics from 1933 to 2023 by decomposing annualised ten-year rolling total nominal performance for US stocks into five complementary sources of return: inflation, real cash return, and term, credit and equity risk premia (see chart)2. The analysis shows that the long-term success of different asset classes is strongly dependent on the inflation and growth regimes. 

Starting with inflation, our analysis observes four distinct regimes: deflationary (1930-1941), disinflationary (1952-1960 and 1985-1999), stable (2000-2021) and inflationary (1942-1951, 1962-1984 and 2022-2023). While based on ten-year averages and not capturing intermediate fluctuations, the regimes provide insights into longer-term trends that are relevant for strategic investment horizons.

Macro regimes drive long-term risk premia 

The decomposition of the annualised ten-year rolling total nominal return for US stocks between inflation, the real return of Treasury bills and US term, credit and equity premia from 1933 to 2023. The data points are sampled on annual frequency from 1924 to 2023. Since the first estimates are calculated using observations from 1924 to 1933, our sample commences in 1933 for this analysis

Sources: Federal Reserve Economic Data at St. Louis Fed, US Bureau of Economic Analysis, the websites of Prof. Robert Shiller (Yale University) and Prof. Aswath Damodaran (New York University), Barclays Private Bank, May 2024

The impact of inflation regimes

The earliest deflationary period coincided with the Great Depression (1929-1933) and a recession (1937-1938). This was a time when US stocks saw their worst historical drawdown, a staggering -65% in 1933. Real returns for Treasury bills gradually eroded, while Treasury bonds, and especially corporate bonds, held up remarkably well, mitigating losses for diversified investors.

Disinflationary periods generally lifted all assets, with equities and Treasury bonds neck-and-neck for the top spot. Equity premiums peaked in the 1950s and performed well in the 1990s, while term premia took off in the 1980s due to falling rates and remained attractive for almost four decades. 

For most of this century, there has been a stable or mildly disinflationary regime. The burst of the dot-com bubble in the early 2000s erased the equity premium. The GFC inflicted one of the worst shocks on stocks and poorly-rated debt.

However, low and relatively stable inflation, coupled with quantitative easing and falling rates in the 2010s, significantly boosted equity and credit premia. This remained stable and historically elevated. Notably, real returns for Treasury bills have been negative  ever since.

Mixed signals

Finally, inflationary periods presented mixed signals for equities, depending on the initial inflation level. Typically, scenarios where inflation accelerated after being low or negative for a period, were favourable for equities, as they coincided with economic recoveries after a recession.  

Conversely, when inflation was high and rising rapidly, equities typically suffered. Nominal Treasury bonds exhibit a strong aversion to inflation, resulting in diminishing or even negative term premiums during inflationary episodes. Treasury bills were less reactive due to their lower duration, but their real returns eventually felt the inflation pinch. However, credit premiums tended to be more resilient in such situations, saving the case for diversification with fixed income even during the worst inflation scenarios.

Fortune favours the calm and composed

Shifts in risk premia over time should not be neglected. However, they are less problematic for a diversified portfolio with different return sources and factor exposures. This allows investors to focus on the long run and rest easier at night.

We’ve only touched on the surface, addressing the first two pillars of long-term investments: staying invested and being well-diversified. Crafting an optimal asset mix involves a comprehensive analysis of various factors and their interplay. There’s no one-size-fits-all solution for investors, each with their own goals. Discipline and adherence to a structured investment process continue to be fundamental pillars of successful investment strategies.


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