Nobody likes losing money. Today, we evaluate the downside profile of several asset classes after adjusting for inflation using historical data.

Across the spectrum of investors, you will find a variety of opinions and preferences, but almost everyone can agree on one thing: nobody likes losing money. Asset allocation is arguably the most important mitigation of portfolio downside. As you add more uncorrelated assets, market risk is typically reduced, thereby facing less potential downside. However, one aspect often overlooked in assessing downside is inflationary risk. Inherent in the asset allocation process is the implicit tradeoff between market risk and inflationary risk. As you decrease market risk by adding more asset classes, expected returns are typically reduced, running a greater risk of inflation eating away at gains. One way to evaluate downside while adjusting for inflationary risk is through real returns, which adjust for inflation. A 10% nominal return may appear impressive at first glance, but if accompanied by 10% inflation, an investor’s real return would effectively be nothing.

Using historical returns compiled by NYU Stern, which primarily sourced data from the Fed, we can find the real (inflation-adjusted) historical risk and return profiles of asset classes since 1970. It's worth noting that the data is primarily based on prices and rates at the beginning of each month and therefore does not reflect intra-month movements.

The following table shows the average real returns of asset classes across one-month to thirty-year rolling periods since 1970. Unsurprisingly, equities outpaced other asset classes. However, the magnitude of outperformance over the long haul may be surprising. For example, the average thirty-year real performance of the S&P 500 (SPX) is almost twenty times that of 3-month T-bills.

Another asset that stands out is gold, which has a surprisingly low long-term return. Gold’s (GC/) real return of 307.9% over the last 30 years is the highest it’s ever been, and its 25-year return of 538% is more impressive. Because gold’s strongest performance has occurred relatively recently, fewer long-term rolling periods include these high-return years. Conversely, periods of lower performance are represented across more samples, which biases the long-term averages downward. As a result, gold’s one-year return may be a more reliable guide for its long-term outlook.

While understanding returns in a vacuum is important, it’s equally important to understand the risks associated with them. When evaluating downside, there are two aspects to consider: frequency and magnitude.

• Downside frequency can be quantified by looking at the percentage of time an asset class has positive real returns.
• Downside magnitude can be captured by asset classes’ max real drawdown and worst real return across different time periods.

Equities have the highest positive real return percentage across most time horizons, but 25-year Baa corporate bonds were also strong at generating positive returns. Since 1970, both equities and corporate bonds have been virtually guaranteed to be positive over 15-year periods. However, equities are known for their sharp declines, which is why evaluating downside magnitude is equally critical.

Unlike the percentage positive metric, equities ranked at the bottom in terms of their one-year and two-year worst real return, with only gold ranking below the S&P 500’s worst five-year return. Although, things start getting interesting at the 15-year mark. The worst real return of the S&P 500 over a 15-year horizon outperforms both three-month T-bills and 10-year treasuries since 1970.

Historical drawdowns reinforce this notion of reduced risk over longer horizons. The S&P 500’s maximum real drawdown—defined as the maximum peak to trough decline adjusting for inflation—was the highest of any asset class besides gold. Regarding the commodity, it wasn’t until April of this year that gold recovered the 83% real decline from its peak in February of 1980—a drawdown of more than 45 years. However, the maximum duration of a drawdown for equities was 12.67 years, which is the shortest of any group besides Baa corporates. Put simply, equities tend to recover faster than other asset classes, even after severe declines.

Fifteen years appears to be a line of demarcation in which inflation is almost guaranteed to be a greater contributor of downside than market risk. This is evident when comparing the fifteen-year rolling real performance of the S&P 500 versus three-month T-bills going back to 1934. Despite SPX being exposed to significantly more market risk, it still outperforms the “risk-free” asset across virtually every economic environment, except for a few 15-year windows ending between the late 70s and early 80s that underwent periods of stagflation.

Typically, the best and worst periods for equities are coupled together, as meltdowns are often followed by periods of strong recovery (e.g., 1987-1989, 2008-2009, 2020). Over long horizons, equities’ strong returns tend to offset drawdowns, leading to consistent outperformance versus both inflation and other asset classes. At fifteen years or longer, the S&P 500 outperforms every asset class in terms of its average return and percentage of positive returns, trailing narrowly behind Baa corporates in minimum 15- and 20-year returns.

Diversified portfolios of both equities and fixed income have historically done well at generating positive returns. To simulate a fixed income portfolio, we assumed allocations of 50% to treasuries, 25% to Aaa corporates, and 25% to Baa corporates. Mixed portfolios of equities and fixed income have positive real returns at a better rate than any asset class at five-year and ten-year time horizons. Diversification also plays a key role in mitigating downside, especially at intermediate horizons. Over a five-year period, a 60/40 portfolio averages 86% of the real return of equities while taking on only 63% of equities’ max loss, which is a strong testament to the power of diversification.

While market risk is often front and center in portfolio construction, inflationary risk deserves equal attention, especially over longer horizons. Real returns offer a more complete picture of downside potential, and historical data shows that equities tend to recover quickly and outperform over time despite their volatility. Meanwhile, diversification remains a critical tool for managing risk, particularly in the short to intermediate term.