2017 Market Commentary - Year-End Review

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2017: The Year of Equities
But Let's Not Forget About Fixed Income

If you were heavily investing in equities throughout 2017 you were handsomely rewarded with attractive returns across various geographies, sectors, and styles. While these returns may provide some temporary comfort and satisfaction, we can't help but turn our attention forward to 2018 and wonder, what's next?

To give some context to the question, we turn to one of our favorite charts - the asset return quilt - which shows broad asset class annual returns over time. The chart is an effective reminder that market returns can, and do, vary considerably year-over-year. Contrary to what some pundits would have us believe, the direction and degree of these variations cannot be forecast with any certainty.

Despite the captivating headlines that came to define our understanding of the 2017 markets, and suggested a rare phenomenon, strong equity returns have been fairly common over the last 15 years.

In looking at the asset quilt, you'll notice that the top three performing asset classes in 2017 were EM Equity (Emerging Market), DM Equity (Developed International), and Large Cap (Domestic Stocks). All of these equity markets had returns in excess of 20%. It's natural to look at these returns as an anomaly caused by recent events, such as the election of a new administration, rebounding oil prices, or tax reform, but returns of this magnitude (top three asset classes returning 20% or more) occurred five additional times in the last 15 years. It's not that uncommon.

Asset QuiltSource: Barclays, Bloomberg, Fact Set, MSCI, NAREIT, Russell, Standard & Poor's, J.P. Morgan Asset Management.

Another common market occurrence that we saw once again in 2017 was the positive spread of equity returns over fixed income returns. For some reason, though, it seems like this spread was more pronounced than years past? One possible reason for our perception is framing bias, which is a cognitive error that we can commit without realizing it.

This is how it might manifest itself. We focus on the news and see that popular equity indices are reaching record highs while unemployment levels continue to drop. Excited by what that means for us, we rush to our investment statements hoping to see a direct translation to our portfolio returns. We're then disappointed to see that our portfolio is up less than 12% when the S&P 500 is up 20%!

Naturally, we forget about the downside protection benefits of fixed income when markets are skyrocketing. Framing bias can cause us to lose track of the bigger picture. Many of us are invested in balanced portfolios roughly consisting of 50% equities and 50% fixed income in order to provide growth while also controlling downside risk. Naturally, we forget about the downside protection benefits of fixed income when markets are skyrocketing. It's only when we see the next market correction in equities that we'll fully appreciate the role fixed income plays in dampening our downside volatility.

It's worth noting, too, that 2017 may have been a watershed of sorts in fixed income. Broad investment grade fixed income returned 3.5% in 2017. While this pales next to 20% equity returns, it represented another year of positive returns for fixed income, and extended the positive returns in bonds we've enjoyed for most of the past 30 years as interest rates have been in decline. With the Federal Reserve announcing a planned reduction in their balance sheet and three interest rate increases in 2018, 2017 may very well go down in history, not as the year of equities, but the beginning of the end of the bull market in bonds. With this fundamental shift in the marketplace, it's even more important for investors to understand the value of bonds as a risk mitigating component in their portfolios.

So how do we navigate the inevitable ups and downs of the market? This answer also lies in the asset return quilt. The balanced asset allocation highlighted by the dot plots through the center of the chart brings to light a fundamental aspect of investing. Diversification across asset classes mutes volatility. By diversifying and building your portfolio around the appropriate level of risk, it doesn't matter whether fixed income or equities outperform in a given year, or if there's going to be a market correction. With the appropriate risk objective in place, your portfolio is designed to withstand market fluctuations over your expected time horizon, and will ultimately provide a clear filter with which to view your investment goals, free from the prevalent traps of the framing bias.

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