Investors will soon receive their year-end statements for 2011 and will be analyzing their returns for what has been a very volatile year. When comparing their portfolio’s returns to popular large-cap indexes, such as the Dow Jones Industrial Average or the Standard & Poor’s 500 Index, many investors may see that their portfolio produced a lower return. In 2011 few well-diversified portfolios matched, let alone exceeded the performance of large-cap stocks. Does this mean that your investment strategy failed last year?

Using exchange-traded funds, here’s a chart showing how various market sectors performed from 12/31/2010 through 12/31/2011:

iShares DJ US Financial Services: -20.45%

iShares MSCI Emerging Markets: -18.80%

iShares MSCI EAFE (international): -12.23%

iShares Russell Microcap: -9.84%

iShares Russell 2000 (small cap): -4.43%

iShares S&P Mid Cap 400: -2.17%

SPDR S&P 500 (large cap): +0.00%

iShares DJ US Real Estate: +5.55%

SPDR Gold Shares: +9.57%

iShares Corporate Bonds: +9.74%

iShares Barclays 7-10 Year Treasury: +15.65%

The third year of a U.S. presidential term has historically been the best performing year for stocks within the four-year presidential cycle. Incumbent presidents have used the third year of their terms to push through economic stimuli in hopes of getting the votes necessary to be re-elected. The gridlock in Washington this year prevented that from happening. Other negative factors included slow domestic economic growth, Europe’s sovereign debt problems, the earthquake in Japan, and a potential decline in China’s economy.As you can see, the S&P 500 was flat for the year. The chart includes six other equity sectors that had losses. Finally, four sectors had gains: real estate, gold, corporate bonds, and U.S. Treasurys. What happened?

The performance numbers in the above chart point out the importance of a fundamental investment concept: the need for allocating your investments among various market sectors. If you had some exposure to the asset categories that did well such as real estate, bonds, and gold, it helped your portfolio. However, even with exposure to these asset classes, most portfolios holding a majority proportion of stocks experienced an overall loss in 2011.

Another thing to note is that diversification worked quite well in 2011. Perhaps it didn’t work the way we wanted, but there was a definite variance in asset class performance. After the gruesome bear market in 2008 when virtually all asset classes declined in tandem, many investors claimed that diversification didn’t work anymore. The good news is that 2011 confirmed diversification does work and that when certain asset categories decline others are likely to increase in value.

The Callan Periodic Table of Investment Returns lists nine asset categories (or sectors) and their annual returns over a period of twenty years, ranked in order from the best-performing to the worst. This table is instructive in several ways.

1. Every year the best-performing asset category has been positive.
2. The nine categories’ rankings often change dramatically from year-to-year.
3. There is no identifiable pattern that can predict the best-performing sector going forward.

Because we investors don’t have crystal balls to predict the future, the best action we can take is to have exposure to each of the major sectors and maintain our asset allocation percentages.

It can be tempting to abandon target allocation percentages that were established when a thoughtful diversification strategy was originally established. Investors are naturally drawn to higher-performing sectors. For example, from 1995 through 1999 large cap growth stocks led the pack by a substantial margin. Consequently, investors threw their money into this asset class with reckless abandon. Then this trend abruptly reversed as small cap value stocks were the #1 performers in 2000 and 2001.

Finally, we should keep in mind the importance of exercising discipline. As W. Scott O’Neil, President of MarketSmith, recently stated, “The trait most common among successful investors is not intelligence, experience or intuition. It’s discipline.”