Investing in asset-allocated portfolios is truly an absurd notion, a paradox. Do I have your attention? Haven’t I been asserting for years that asset-allocated portfolios are the best strategy to invest for long-term investors who desire gain but cannot afford significant losses?

Yes. So let’s look at the definition of paradox: “A seemingly absurd or self-contradictory statement or proposition that when investigated or explained may prove to be well-founded or true.”

I bring you to recent history. The S&P 500 has been on a tear lately. In 2014 and three-year period from 2012 to 2014, the S&P has returned 13.69% and 20.41%, respectively. The conventional response from some folks this year might be: “I want those S&P 500 returns! Isn’t that the market? I want at least or close to market returns!” But, you really don’t want those returns (to have held only the S&P 500), even though your asset-allocated portfolio has recently lagged this index.

Sounds absurd? Well, you see, it’s a paradox. Investigate a little further and you’ll find this to be true.

An excellent article in the March 14 edition of Financial Planning Magazine, “Embracing The Average,” Article Link http://digital.financial-planning.com/financialplanning/201403?folio=75#pg97 explains this well.

“As it turns out, since 1970, the S&P 500 has beaten the diversified portfolio 55% of the time–sometimes dramatically. In 1998, for example, the S&P 500 had a return of 28.58% while the multi-asset portfolio (60% stocks/40% bonds) returned 0.96%.” 2014 was similar, but not as dramatic.

Yet, the two ended up with a 44-year performance that was basically the same, with less risk for the diversified portfolio (that includes bonds and cash).

“The explanation lies in the down years. There were more of them for the S&P 500 (nine losing years versus five for the multi-asset portfolio), and the depth of the losses was far greater. Moreover, both advisors and clients need to keep in mind one important rule: Negative returns are disproportionately more damaging to a portfolio than positive returns of the same size, because the loser portfolio must work so much harder to catch up.”

So, comparing the S&P 500 to your asset-allocated portfolio is an exercise in futility that will only bring anxiety and misunderstanding. But if you are still holding on to this notion, what would have been your thoughts had you held only the S&P 500 in 2000, 2001 and 2002? You would have had bottom-feeding returns of -9.1%, -11.9%, and -22.1%, respectively, relative to other asset classes. Would you still be pining for the S&P 500?

An asset-allocated portfolio will consist of about eight general asset classes such as large cap stocks (S&P 500), small cap stocks, bonds, REITs, international stocks, etc. The important thing to understand is that an asset-allocated portfolio will never do as well as the best-performing asset class for any given year. Most importantly, it will never do as bad as the worst-performing asset class for any given year. In the following  chart (link below) you’ll see how the asset-allocated portfolio (AA) returned consistently year by year, but was never the best or the worst when compared to other asset classes. http://novelinvestor.com/asset-class-returns/. It’s a classic turtle vs. hare story and sets up asset-allocated investors with “investor envy.” (I want that other investment that did so well last year.)

The crux of the paradox is that you can’t, with consistency over years, predict which asset class will be the best or worst for any upcoming year. For further perspective on this, have a look at “The Investor’s Definition of Insanity: Ritholtz Chart” from Bloomberg View, March 20, 2014. In this chart, you’ll see that again, the asset-allocated portfolio (AA) consistently moved forward, never doing the best but also never doing the worst. http://www.bloombergview.com/articles/2014-08-20/the-investor-s-definiton-of-insanity-ritholtz-chart

The moral of the story is one of long-term understanding and the difference between speculating and investing. For the prudent investor, betting on the S&P 500 or any other asset class, sector, or company is speculating, while globally diversified asset-allocated portfolios utilizing index funds is investing. When someone says “Look how well I did,” it’s hard to fight investor envy. But, history shows us asset allocation is the right approach.

2014 Q4 Review: Selected Indexes & Model Portfolios

Through 12/31/2014

(Table Disclosures) Performance for periods greater than one year are annualized. Selection of funds, indices and time periods presented are chosen by the client’s advisor. Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio. Past performance is not a guarantee of future results. Russell data copyright © Russell Investment Group 1995-2013, all rights reserved. The S&P data are provided by Standard & Poor’s Index Services Group. MSCI data copyright © MSCI 2013, all rights reserved. Barclays Capital data provided by Barclays Bank PLC. * 100% globally diversified stock portfolio net of expenses and fees  ** 60% stock 40% bond portfolio net of expenses and fees  

Welcome to 2015, another year that offers new uncertainty–since no one really knows what it will bring us. But, it’s a good time to look back at 2014, a year many pundits believed was going to be bad for stocks.

Looking at the selected asset classes for the one-year period, U.S. REITs had a banner year, returning 30.26%, followed by the S&P 500 and Global REITs with returns of 13.69% and 11.88%, respectively. Small companies (Russell 2000) were not exciting at 4.98%. Emerging Markets pulled back with -1.82%, while international stocks (EAFE: Europe Asia Far East) was the worst-performing asset class for the year at -4.48%.

U.S. bonds fared favorably even to some stock asset classes in 2014, with the U.S. Aggregate Bond Index returning 4.92% while Global Bonds lagged the U.S., returning 0.59%.

Consolidating to portfolio performance by looking at the WorthPointe 100% stock and 60% stock/40% bond hypothetical portfolios (WP100 & WP60), it’s easy to see that investors experienced a paradox year for 2014, with 2.44% and 1.67% returns, respectively, net of all expenses and fees. Along with the asset allocation nuances discussed above, any tilt toward smaller companies did not seem to help in 2014.

Trying to find a pattern in short-term data is easy to do but usually ends in false conclusions. It’s not until you look at the longer term 10 Years and Since Inception (Since 12/1/1990) columns that you see the power of asset allocation. With Since Inception returns of 11.30% and 8.72% for for the WP100 and WP60 portfolios, respectively, you get an idea of the wealth-building potential of asset-allocated portfolios over the long term. Importantly, the picture looks even better when you look at the lesser risk taken in asset-allocated portfolios vs. specific asset classes like the S&P 500.

In closing, do not get lost in the paradox of 2014. If you want your investments to last, remember that our investigations into the science of investing are well-founded: a paradox explained.