Stocks, bonds — nearly everything — underperformed in 2022. What’s an investor to do?

Mark Twain warned us about learning false lessons: “We should be careful to get out of an experience only the wisdom that is in it and stop there, lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and that is well but also she will never sit down on a cold one anymore.”

Last year was tough for investors. Traditional assets — stocks, bonds, funds, ETFs — took a drubbing. Many indices dropped 20% or more.

Non-traditional assets — Bitcoin, precious metals, collectibles — underperformed, too. There was almost nowhere to hide.

I think 2022 taught us a false lesson about diversification.

Diversification just looked bad in 2022. I mean, since everything tumbled, what’s the point? It truly was a year when holding everything in a bank account or money market fund outperformed nearly everything else.

Any decent portfolio mix will both underperform and outperform some of the parts. If the mix is good, it will do better in the long term than the mathematical average of the segments. That’s the Nobel Prize-winning science of Modern Portfolio Theory (MPT).

From a pure performance standpoint, I’d always want to be exclusively in the highest-performing segment. But the highest-performing segment isn’t predictable, so I don’t believe that’s possible.

Instead, I choose a mix that includes all the high-performing assets and simply understand that my annual portfolio performance will lag some of the parts.

For example, I couldn’t drive my Porsche as a daily driver. It’s fun to drive, great to look at, and an exceptional machine for some routes. It’s terrible on snow, cramped for lengthy trips, and the manual transmission requires too much attention in the mountains. It’s absolutely the best car I own from a pure performance standpoint, though.

Getting back to the growth assets, let’s say that A, B, C and D have long-term growth averages of 10%, 12%, 14% and 16%. If they all performed consistently year after year, I’d put all my money in the 16% asset D. If I can’t predict, but they still maintain their long-term averages, I’d split them up equally and easily earn 13% each year.

MPT shows us that the long-term performance will actually exceed 13%. However, it will probably get beaten in all years by at least one of the assets. We’re not sure which one.

Several growth-market segments have outperformed large company U.S. based stocks at certain times, and sometimes for years or even decades. Small companies, international and emerging market stocks are examples.

There is a related point, though. The annual volatility for growth assets is daunting. Even knowing the math and being a professional, it’s hard to endure a 40% to 50% correction on an entire portfolio even if I think it will come back later. That’s why I temper the portfolio with non-growth assets. Again, I know this will reduce long-term performance, but (MPT, again) not as much as it might appear.

This all works and is uncontested, mathematically speaking. Today’s question is more observational: Is there a lesson to be learned from 2022? I mean, a real lesson, not the false one about which Twain warned?

I think there is.

The year 2022 was an anomaly. It didn’t disprove investing or even diversified investing as a long-term strategy. Instead, the wisdom lies is sticking to our plans and knowing that they will work in the long run.

One year — no matter how bad — is a false lesson.

Dan Danford is a CERTIFIED FINANCIAL PLANNER professional and a member of Financial Planning Association of Greater Kansas City. He is founder/CEO of Family Investment Center in Kansas City and St. Joseph, Missouri. Danford is a practicing Investment Advisor and author of “HAPPY TO BE DIFFERENT: Personal and Money Success Through Better Thinking.”

This story was originally published January 11, 2023 at 6:30 AM with the headline "Stocks, bonds — nearly everything — underperformed in 2022. What’s an investor to do?."