When people think about investing for the long run, they often look to average market returns. For example, the broad U.S. stock market delivered a 10.0% average annual return over the past 30 years through the end of 2018, while the average annual return for bonds was 6.1%. However, stocks rarely delivered the average return in any given year—in fact, they did so only twice since 1989. Instead, as shown in the chart below, stock market returns swung widely, from up nearly 40% to down nearly 40%.
Figure 1: Annual stock and bond returns were rarely "average" over the past 30 years
Source: Morningstar Direct, 1/1/1989 – 12/31/2018. Indexes used are: stocks, S&P 500® Index; bonds, Bloomberg Barclays U.S. Aggregate Bond Index. Indexes are unmanaged and cannot be invested in directly. Past performance does not guarantee future results.
By contrast, bonds generated close to their average return about five times over the 30-year period, and showed much less variance from year to year—returns ranged from a gain of approximately 18% to a decline of about 3%. Additionally, bonds were up when stocks were down, and vice versa.
Given their different characteristics, including a mix of stocks and bonds, with the amount of each determined by your risk tolerance, can help to diversify a portfolio and potentially generate a smoother pattern of returns over time.
The right mix may include many asset classes
U.S. stocks and bonds aren't the only potential ingredients in the recipe. Other asset classes, such as international stocks, real estate investment trusts (REITs), gold and other precious metals, and cash each have their own unique characteristics that can help diversify a portfolio. Of course, they each come with different investing risks, as well.
As shown in the chart below, a hypothetical portfolio that held a mix of U.S. and international stocks, bonds, commodities and cash delivered strong growth over time, but with less volatility than stocks alone.
Figure 2: Diversified portfolio delivered smoother performance over time
Source: Morningstar Direct, 1/1/1999 – 12/31/2018. Indexes used are U.S. large cap stocks, S&P 500® Index; U.S. small cap stocks, Russell 2000® Index; international stocks, MSCI EAFE Index; core bonds, Bloomberg Barclays U.S. Aggregate Bond Index. The diversified portfolio was rebalanced annually and consists of 25% U.S. large cap stocks, S&P 500 Index; 10% U.S. small cap stocks, Russell 2000 Index; 20% international stocks, MSCI EAFE Index; 24% core bonds, Bloomberg Barclays U.S. Aggregate Bond Index; 8% high-yield bonds, Bloomberg Barclays U.S. Corporate High Yield Index; 5% gold and other precious metals, S&P GSCI Precious metals Index; 8% cash, IA SBBI US 30-Day Treasury Bill Index. Not representative of any specific investment or account. Indexes are unmanaged and cannot be invested in directly. Past performance does not guarantee future results.
Stay diversified: Don't try to chase short-term performance
Short-term performance across asset classes can vary significantly from year to year. It can be tempting to look at the best-performing asset class in any given year and question why you're invested in asset classes that haven't performed as well recently. But leadership across asset classes tends to vary from year to year, so generally a better strategy is to diversify across a mix of stocks, bonds, commodities and cash to benefit from exposure to whichever asset classes are performing well at any given time, while also helping to dampen the volatility of your overall portfolio.