Many investors think of a simple portfolio of US stocks and bonds as their basis of comparison, but the truth is that we need to maintain a wider view of diversification in order to earn its benefits. (UBS)

While it's true that stocks and bonds have both experienced losses in 2022, this does not mean that diversification didn't work. Diversification helped to improve returns within both fixed income and equity portfolios—and for those who held alternatives, they have demonstrated diversification benefits, helping to stem losses.

Many investors think of a simple portfolio of US stocks and bonds as their basis of comparison, but the truth is that we need to maintain a wider view of diversification in order to earn its benefits. Heading into 2022, many investors found themselves under-allocated to parts of the portfolio that had underperformed in recent years—such as commodities, hedge funds, value stocks, and international stocks—and holding an overweight to some parts of the market that had experienced a long stretch of outperformance.

US growth stocks had benefited from a long-term trend of falling interest rates, and so they were susceptible when that trend reversed. In 2022, US large-cap value stocks, which feature a heavy weight to the energy and financials sectors, delivered strong returns, helped investors to outperform the S&P 500 handily in the rising rate environment.

To maintain diversification, investors need to be careful to maintain a strategic balance between growth and value exposure, including a healthy allocation to international markets, to help balance out the relatively concentrated stock and sector exposure in the S&P 500. It’s not too late to make that change now—years of growth outperformance haven’t been completely erased by a few months of value outperformance.

Cash managed to add value in 2022, simply by holding onto more purchasing power than other parts of the portfolio. However, it has still lost more purchasing power since the global financial crisis than in any other period in modern history, and will continue to be a poor long-term investment going forward—especially with short-term interest rates remaining below the level of inflation. Investors can boost their diversification benefits, and their expected returns, by investing any excess cash that they don't need for short- and medium-term spending needs.

For the last 40 years, intermediate- and long-term bonds benefited from falling yields. With rates near all-time lows after COVID-19, investors put on a global hunt for yield, with some piling into high yield bonds. In 2022, rising rates hit many yield-seeking strategies, with long-maturity Treasuries experiencing losses greater than equities. Diversifying into short-duration bonds and senior loans has helped mitigate losses.

The outlook for bonds has clearly improved. The duration risks that produced poor fixed income returns this year have been priced into markets. With rates now above 4% and the Federal Reserve getting closer to its terminal rate, bonds now offer a much better starting yield and have a larger buffer to absorb losses, making them a more attractive diversifier going forward—especially if you maintain the position long enough for markets to begin pricing in a Fed pivot that is likely to occur in 2023.

Commodities remain a relatively poor long-term investment, but they proved their worth as a tactical asset class in 2022. We had a “most preferred” tactical stance on commodities for most of 2022, where rising prices helped investors to offset some losses in the stock and bond markets. Due to supply-demand dynamics, we continue to have a “most preferred” view on crude oil, and a preference for US energy stocks—in both cases, an allocation to these asset classes can help investors to protect against the risk that inflationary pressures are more resilient than expected.

Conclusion: Diversification is not broken
Diversified portfolios are beneficial because they are characterized by resilience and robustness, tending to offer better risk-adjusted returns, lower drawdown risks, and greater value from portfolio management strategies such as rebalancing and tax-loss harvesting. In short, diversification helps to reduce the role of “luck” in investment outcomes by tapping into a broader variety of driving factors.

In order to maintain a diversified portfolio, we need to hold onto—and even add to—asset classes that have underperformed in recent years. This brings us to a final thought that you may want to discuss with your financial advisor, and bear in mind for future performance review discussions: If there's something in your portfolio that you hate, it's a good sign that you're diversified. By the same token, if everything is working at once, there's a chance that your portfolio will experience an environment where everything stops working at once.

Main contributors: Daniel J. Scansaroli, Justin Waring, and Calum Leonard

This content is a product of the UBS Chief Investment Office.