The Market’s Unexpected Ride in 2023 Highlights Why Diversification Matters

Investing can be an emotional exercise. It’s your hard-earned money, and you want to make sure it’s working hard for you. We frequently hear from clients who are concerned about why they’re invested in asset classes that don’t perform as well as others. It’s natural to want to concentrate your portfolio into what’s working well now.

The problem is that what’s working well now isn’t likely to continue to work well into the future. 2023 provided another stark example of how quickly the economic and investing landscape can change. In 2023 investors faced a vastly different—and mostly positive—environment compared to 2022. However, one constant remained: the annual reshuffling of performance rankings for the asset classes.

Here’s a look at what worked well in 2023, what didn’t, and why a diversified portfolio is the best long-term path to building and protecting wealth.

The risk associated with Large Cap Stocks’ dramatic comeback

Early in 2023, when fears of a recession were elevated, investors flocked to the perceived safety of large companies. The migration to larger names accelerated as the year wore on, and investors began to believe that large, technology-focused companies would benefit if the Fed was nearing an end to its rate hiking cycle. As such, Large Cap equities, as represented by the S&P 500, were the top-performing asset class (a significant reversal from 2022, when they finished near the bottom).

Even though Large Cap equities have been a top three finisher for eight of the last 10 years, the recent performance may be deceiving. The recent gains were driven by a cluster of companies dubbed “the magnificent seven.” While the quality profile and growth prospects of these companies are better than the average S&P 500 company, it does raise the risk profile of the index, as a large degree of optimism is priced into a concentrated subset that makes up around 30 percent of the total index.

“The strong performance for Large Caps may look like the group is returning to the position of strength it enjoyed in the years leading up to COVID. However, details of the performance highlight how fragile the gains may be and serve as a reminder that, historically, the asset class has had its share of challenges,” says Steve Bruce, assistant director of Advisory Investments at Northwestern Mutual.

Large Cap stocks haven’t always been perennial top performers. From 1998 through 2012, large cap stocks finished in the top third of asset class performance only two times. Over the course of a decade, investors have gone from avoiding large cap stocks to overweighting them in their portfolios.

“Diversification helps solve this all-or-nothing mentality and can help steer investors away from potential pain caused by chasing performance,” Bruce says.

From top to bottom, Commodities’ dramatic fall

On the other end of the spectrum were Commodities, which were 2022’s top-performing asset class and one of only two groups to post positive returns amid inflation and the war in Ukraine. However, in 2023, the group was at the bottom of the performance heap and the only asset class to finish in the red for the year.

Valuations and economic optimism drive returns for smaller companies

While Large Cap stocks benefited from investors’ willingness to pay higher valuations for perceived safety and expectations of growth in the long term, shares of Small Cap and Mid-Cap companies enjoyed a resurgence during the year thanks to appealing valuations and expectations that the economy may be able to avoid a contraction.

“These asset classes have already been marked down in anticipation of a mild recession, and they typically do well coming out of a downturn,” says Brent Schutte, chief investment officer of Northwestern Mutual Wealth Management Company. “While our base case remains a short, mild recession in the coming quarters, we believe the attractive valuations could help mitigate some of the downside risk associated with an economic contraction and lead to meaningful performance when the economy recovers.”

Fixed income regains its footing

Fixed income investors who weathered historically poor performance of bonds in 2022 were rewarded for their patience in 2023. After a solid start to the year, bonds dipped into negative territory in late spring and throughout the summer but posted gains for the full year. The surge in performance began after yields on the U.S. 10-year Treasury peaked at more than 5 percent in October and then quickly receded to less than 3.9 percent to end the year as investors concluded the Fed was done raising rates and may start cutting them as early as March of 2024. Yield and performance for bonds have an inverse relationship.

“After years of watching equity markets do the heavy lifting, bonds at current yields should play a more active role,” says Schutte. “As measured by the Bloomberg Aggregate index of U.S. investment-grade fixed income, bonds have provided meager or, in some cases, negative returns on an annualized basis over the past three-, five-, 10- and 15-year bases. The reality is that starting yields across each of those time frames were low, and as such, performance followed suit. Now, with investment-grade fixed income yielding north of 4 percent, we believe bonds are likely set to provide positive mid-single-digit returns in the coming years.”

The case for diversification

As we do at the end of each calendar year, we review the performance of various asset classes featured in what we call “the quilt.” It’s simply a color-coded chart that ranks, from highest to lowest, the returns of various asset classes each year. When you map it out across 15 years, you get something that looks like a messy patchwork of colors or a crazy quilt that’s been stitched together with no rhyme or reason. The random picture it creates vividly illustrates the unpredictable nature of markets and the importance of portfolio diversification for the long term.

While the performance of individual asset classes can flip top to bottom (or vice versa) in the span of a single year, the one constant through the middle of the chart is a diversified portfolio.

“You often hear that your time in the market is ultimately more important than timing the market—diversification is a guiding principle of that statement. It simultaneously acknowledges that it is impossible over the long run to consistently pick the top-performing asset class, and it reduces the risk of catastrophic losses that can derail an investor’s future financial plan,” says Bruce.

Looking forward

As we look ahead to how the next 12 months will play out, it’s worth keeping this asset class performance chart in mind. Inflation is lower, but wage pressures remain, and we believe a mild, shallow recession may arrive in the coming months. Additionally, while the Fed is expected to cut rates at some point in the coming year, the timing of any reduction is unknown and subject to considerable debate. These are just a few potential scenarios visible on the horizon. As we’ve all been reminded repeatedly since the arrival of COVID, there are always unexpected events that ripple through the markets without warning. The future is unknown in the near term.

That’s the key benefit of diversification, and those who stick with it may be in a stronger position in the long run—especially given that markets are likely to continue to vary from one year to the next.

Additionally, a smart investment strategy leads with a steady outlook and looks through an objective lens that incorporates valuations and considers where we are in the economic cycle, the forward path of monetary and fiscal policy, and market structure.

At Northwestern Mutual, we build financial plans that take a comprehensive view of your situation that goes beyond simply your investments to make sure you’re able to reach your financial goals, even if life throws you a curveball.

“Taking a holistic approach that includes setting aside a portion of wealth in a tax-favored, non-correlated asset—such as permanent life insurance or an annuity—can provide investors the flexibility to meet their liquidity needs during times of market volatility,” says Bruce.

The primary purpose of permanent life insurance is to provide a death benefit. Using permanent life insurance accumulated value to supplement retirement income will reduce the death benefit and may affect other aspects of the policy.

*Compounded returns are measured by the geometric mean of a given portfolio, which takes into account the sequence of returns over a given period of time and more accurately shows the portfolio’s performance over that period of time, as compared to a simple average. **Risk is represented by standard deviation, which is the measure of total volatility in a portfolio. It shows how widely a portfolio’s returns have varied around the average over a period of time. Standard deviations on this chart were calculated using monthly returns.

Sources for asset class chart:

U.S. Large Cap: The S&P 500® Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

U.S. Mid-Cap: The S&P Mid Cap 400® Index measures the performance of 400 mid-sized companies in the U.S., reflecting this market segment’s distinctive risk and return characteristics.

U.S. Small Cap: The S&P Small Cap 600® Index is a market-value weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation.

Int’l Developed: The MSCI EAFE® Index Net Total Return measures the equity market performance of developed markets (markets domiciled in high-income countries, as defined by the World Bank, that most investors consider having a well-developed operating and regulatory structure for its capital markets), excluding the U.S. & Canada. The index returns are calculated with reinvestment of net dividends after the deduction of applicable non-resident local withholding taxes.

Int’l Emerging: The MSCI Emerging Markets® Index Net Total Return measures the equity market performance of emerging markets (markets domiciled in lower-income countries, as defined by the World Bank, but are experiencing rapidly developing economies). The index returns are calculated with reinvestment of net gross dividends after the deduction of applicable non-resident withholding taxes.

Real Estate: The Dow Jones U.S. Select REIT Index is composed of companies whose charters are the equity ownership and operation of commercial real estate and that operate under the REIT Act of 1960. Each REIT in the REIT Index is weighted by its float-adjusted market capitalization. The total return version of the index is calculated with gross dividends reinvested.

Commodities: The Bloomberg Commodity Index (BCOM) is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.

Fixed Income: The Bloomberg U.S. Aggregate Index measures the performance of investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS. It rolls up into other Bloomberg flagship indices.

Cash Alternatives: Cash alternatives are represented by the FTSE 3-Month Treasury Bill Index with income reinvested, representative of the three-month Treasury bills.

Diversified Portfolio: A portfolio of all segments disclosed above, with the following weightings: 23% U.S. Large Cap; 6% U.S. Mid Cap; 3% U.S. Small Cap; 13% Int’l Developed; 6% Int’l Emerging; 4% Real Estate; 5% Commodities; 38% Fixed Income; 2% Cash Alternatives.