Data source: FactSet

The benefits of diversification rarely get their due — until equity markets go down. The advantages of holding a diversified mix of assets guided by individual circumstances is a long-studied and well-documented concept in financial markets. But no one brags to their neighbors over the fence about risk-adjusted returns. That is, until the unexpected occurs, as it has recently with the COVID-19 outbreak.

Near-term implications

Financial markets understandably turned lower as the virus threat grew into a global health risk. The actions taken to limit the contagion require a reduction in consumer and business activities until the human health risk subsides.

AFL’s JoAnne Reilly

Such actions are expected to produce historically poor economic results over the near-term.  However, financial markets typically focus on expected conditions six to 12 months in the future. As such, rather than taking guidance from backward-looking economic data, we believe markets will maintain their focus on the virus itself and the successes or failures in getting it under control. Ultimately, we believe economic data may look its worst long after financial markets have started to recover.

We believe it’s important to note that the U.S. economy entered this period of uncertainty from a position of strength. This should help aid recovery prospects as the COVID-19 situation eases. Consumer debt burdens have been low, and aggregate income has grown faster than consumer spending, a dynamic reflected in a rising personal savings rate. In 2019, the personal savings rate was 7.9%, its second-best level in more than 25 years, according to the Commerce Department.¹

Diversification’s time to shine

It’s natural for the emergence of threats such as COVID-19 to cause fear and anxiety. However, one principle of successful investing is to not allow emotions to overtake the rational, long-term investment decisions you made during calmer times.

History proves that a diversified mix of asset classes (stocks, bonds, alternatives and cash) can help reduce portfolio volatility during challenging market environments. For example, as stock prices drop, bond prices typically rise, thus balancing the total value of the holdings.

Through March 23, the S&P 500^® Index was down 30.4% year-to-date. The Bloomberg /Barclays Aggregate Bond Index, meanwhile, was up 1.0%. Utilizing these two benchmark indices, conservative investors who allocated 70% to fixed income and 30% to equities would have seen their portfolio decline a more manageable 8.4%. Moderate investors with portfolios allocated evenly to equities and fixed income would have realized a drop of 14.7%. This is still a difficult decline, but materially less than the equity market alone.

What else works?

This is certainly not the first time financial markets have dealt with such problems and uncertainties, nor will it be the last. Past episodes show that it rarely works to try to time the market, especially during these periods. Most market research shows it’s nearly impossible to get out of the market right at a top and back in just as it bottoms. Investors who become too fearful on the way down often remain too fearful to get back in as stocks recover.

For investors in the accumulation phase, dollar cost averaging programs are especially beneficial during periods of market volatility. Following a systematic investment process — even during market downturns — may result in a lower average cost basis.

Planning for the unexpected

Since 1948, the S&P 500^® Index has experienced 26 corrections, defined as periods when stock prices declined by 10% to 20% from their recent highs. These periods produced an average decline of 13.7% and an average recovery time of about four months.

In addition, the S&P 500 has experienced 12 bear markets, defined as a decline of 20% or more from recent highs. The average decline during these periods was 32.5%, and the average recovery time was 24 months. Nevertheless, as challenging as it may have been to investors during the downtimes, the S&P 500 today is exponentially higher than where it began in 1948.

Summary

During the 10-year economic expansion through 2019, the S&P 500 experienced eight declines of 10% or more and seven declines of 5% to 10%. Each period of decline likely concerned investors, but hindsight shows that those with a long-term strategy based on their financial goals and risk tolerance likely benefited from maintaining a diversified portfolio and sticking with it. Given the recent market pressures, now may be a good time to contact your advisor to rebalance your investment portfolio back to your target allocations.