By: Steven Karsh

How did your portfolio hold up in 2022? If you owned only stocks and bonds, it was a brutal year and historically bad for a 60/40 portfolio. The Bloomberg Aggregate Bond Index was down 13%, more than four times the previous worst return since 1926. Equities didn’t fare much better as stocks were down over 18% as measured by the S&P 500. Below are two tables from Blackrock identifying the 10 worst years in the U.S. stock and bond markets since 1926.

A 60% stock/40% bond portfolio would have been down 16.2%; a steep decline for a moderate risk/return portfolio.

Bonds have historically been a risk mitigator in portfolios, but not this time around. Other asset classes such as hedge funds, real estate, real assets and commodities all fared much better than both stocks and bonds in 2022.

Adding alternative investments that have a lower correlation to both stocks and bonds can enhance portfolio returns over the long term and in most cases, help minimize the downside risk during rocky periods for stocks and in some cases, bonds. Below is a chart highlighting the maximum drawdown (peak to trough) for various asset classes during the last three stressful periods in the equity markets.

In 2022, a highly diversified portfolio* consisting of global stocks, U.S. bonds, hedge funds, direct real estate, real assets and commodities would have lost only 11.5%, outperforming the 60/40 portfolio by 4.7%; highlighting the benefits of using alternative investments to improve downside protection and increase the chances to reach long-term objectives.

Looking back at the causes of both the stock and bond markets’ decline it’s easy to see why they took it on the chin. Inflation spiked to a 40-year high due to money supply growth and government spending after COVID. The Federal Reserve (FED) kept interest rates artificially low, and Congress went on another spending spree, all leading to an economy with lots of excess cash. Add in supply chain issues related to COVID along with a large labor shortage leading to a jump in wages and it’s no surprise that inflation reared its ugly head.

To get a grip on inflation and slow the economy, the FED started raising interest rates at the fastest pace in over 40 years. This caused bond prices to tank (interest rates and bond prices move in opposite directions) and has increased the likelihood of a recession sometime in the next 12-18 months. With companies having to endure higher labor costs, profit margins shrink, resulting in reduced earnings expectations and thus lower stock prices.

Looking forward, with market declines come opportunities.  As inflation is starting to come down, we are hopefully near the end of the FED rate hiking cycle which bodes well for stocks and bonds. The chart below from Blackrock shows returns for both following the end of interest rate hikes.

Looking forward even further than a year out, markets have a bright outlook over the medium to long term as the chart below shows.

After a year like 2022, it’s no surprise that investors and consumers alike are pessimistic about the future but as the chart below shows, just when sentiment tends to bottom out, it has historically presented a buying opportunity.

So, despite a historically bad fixed-income market and a very rough equity market in 2022, keeping your eye on the long-term and maintaining a diversified portfolio, patient investors should be able to weather the storm we witnessed last year and look forward to brighter times ahead.

*Diversified Portfolio – 48% global stocks, 27% U.S. bonds, 10% hedge funds, 5% direct real estate, 5% real assets and 5% commodities

Mr. Karsh is a Principal at Innovest Portfolio Solutions, a Denver-based independent registered investment advisor.