Mean reversion & asset allocation

At the end of 2014 everyone was updating this chart, showing how various asset classes have performed over time:

JPM AA Quilt 2014

 

I know this gets passed around a lot, but I love this chart.  It is a quick and easy way to see what happened with various asset classes.  It shows us what added to performance last year, and what detracted. The chart above includes Large Cap US Stocks, Small Cap US Stocks, Developed International Stocks, Emerging Markets Stocks, Commodities, US High Quality Bonds and Cash.

Reviewing historical asset class performance teaches us something simple but extremely important:  Mean reversion happens over time, but you can’t predict when. Winners become losers and losers become winners.  Asset classes that have been in the dumps will spring back to the top, much like REITS did, dragging near the bottom in ’07 – ’08 and then quickly shooting up the chart from ’09 – ’12. Emerging Markets go from loved to unloved faster than you can spell BRIC. Commodities were the darlings of the investment world through 2007, and have been abysmal since 2011.

The broader point is that you have no way of knowing when the tides are going to turn.  Developed international stocks looked great coming out of the recession, but that hasn’t lasted the entirety of the current bull market as US stocks (aided in a relative measure by the US Dollar) have handily beaten their foreign counterparts for a few years.  There is no rule about how long these trends last.  You’ll find data somewhere telling you what the average period is, but that number is a meaningless statistic.  Remember that average isn’t normal and what happens over the long term isn’t what happens every year.

You won’t be surprised at what comes next: since we cannot predict which asset class will outperform this year or for how long, investors are best to stick with a broadly diversified portfolio and a disciplined rebalancing strategy, and leave the short-term forecasting to the meteorologists.

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