Published Wednesday, February 13, 2019 at: 7:00 AM EST
The most important financial news of 2018 was that Modern Portfolio Theory (MPT), the strategic underpinning of prudent investing, worked. Yet you just don't see front-page headlines saying conventional wisdom worked. Why? Because when what's expected to happen actually occurs, it's not news. Nonetheless, the fact that modern portfolio theory worked, just as academia has expected it would, was the most important financial news of 2018.
Performance of an equal-weighted portfolio of seven assets for the 49 years through 2018 validated the theory pioneered in academic research in 1948 by Harry Markowitz. MPT holds that a broadly diversified portfolio rebalanced periodically is the best way to get equity-like returns with less risk. The Standard & Poor's index of the 500 largest publicly-held companies over the 49-years averaged a 10.21% return annually and a 16.98% standard deviation (risk rating), compared with a 10.23% risk rating and 9.48% return on a broadly diversified portfolio. This big news happened in plain sight — as it does every year — and, as always, it occurred so very slowly that it was easy to overlook. Based on monthly portfolio design research reports we license by Craig Israelsen, Ph.D., who's taught this class annually for three decades, here's what happened.
In January 2019, the Jubilee year of the modern era of investing, the wisdom of MPT was confirmed: A broadly diversified portfolio over the near half-century long period averaged a return annually on par with stocks but with much less risk! The data on these seven indexes representing these asset classes only goes back to 1970, which is why having another year of data supporting the theory is important confirmation that this relatively new theory explaining investing is correct. Despite the stagflation of 1970s, high inflation of the 1980s, boom and tech crash of the 1990s, the credit bubble and financial crisis of 2008, and current uncertainty, a prudent course of moderation and quantitative analysis has worked as expected for another year.
The 9.48% total return on the diversified portfolio is comparable to the return on a 100% large stock portfolio, the best return of the seven assets, but the diversified portfolio's risk was much lower. The third-best return across the seven types of asset classes was the 8.42% annualized return on non-U.S. equities, which was an equity-like return, but its 21.75% standard means it carried more than twice the price risk of the diversified portfolio.
The number of losing years and worst three-year performance also add context for understanding the relative risk of the seven asset classes versus the equal-weighted diversified combination of the seven types of assets. In seven of the 49 years, the diversified portfolio suffered negative returns versus 15 losing years on the top-performing asset class, and the worst three-year loss was 13.37% on the diversified portfolio, much lower than the 37.61% drawdown on the S&P 500.
Although the news that a broadly diversified portfolio from 1970 through 2018 worked just the way conventional wisdom said it would did not make headlines, it was the most important financial news story of 2018.
Past performance is not a guarantee of your future results. Calculations by Craig Israelsen, Ph.D. Indices are unmanaged and not available for direct investment. Investments with higher return potential carry greater risk for loss. Raw data source: Steele Mutual Fund Expert. Asset class and style data reflects performance of the following indexes:
US Large Cap: S&P 500 Index (TR)
US Mid Cap: S&P Midcap 400 Index (TR)
US Small Cap: S&P Small Cap 600 Index (TR)
Non-US Developed: MSCI EAFE Index NR USD
Emerging: MSCI EM Index GR USD
Real Estate: S&P Global REIT Index TR USD
Natural Resources: S&P North American Natural Resources Index TR
Commodities: Deutsche Bank Liquid Commodity Optimum Yield, Diversified Commodity Index Total Return
US Bonds: Barclays US Aggregate Bond Index TR USD
TIPS: Barclays U.S. Treasury US TIPS Index TR USD
Non-US Bonds: Barclays Global Treasury Index TR
Cash: USTREAS Stat US T-Bill 90 Day TR
This article was written by a professional financial journalist for Advisor Products and is not intended as legal or investment advice.