From the February 2013 issue of Futures Magazine • Subscribe!

Diversification for a brave new world

Traditionally, smart investing has been thought of as a matter of selecting a basket of diversified equities. Cautious investors would add a bond allocation — say of five-year Treasury notes — using about 40% of their portfolio. Then, the investor simply stayed put for a sufficiently long period of time.

Over the past 40 years, this approach generally has worked. Returns have been generous. The S&P 500 stock index, the preferred proxy for a basket of stocks would have, all by itself, provided investors with a lucrative 9.84% compounded annual return, beating out most other individual investment vehicles. However, the index has sported a standard deviation (a statistical measure of volatility and an accepted proxy for risk) of 18.16%. This amount of risk is considered more than moderate. Cautious investors, those who also invested in bonds, would have generated a 9.48% return, but the standard deviation of their returns was a much more reasonable 11.42%.

An investment in equities alone in your portfolio would see your nest egg grow by almost 10% a year, but with a fair amount of volatility. Add in a bond allocation, and expected returns would fall slightly but with a much lower risk profile. This thinking is simple, straightforward and backed up by history and math. It would appear to be all a would-be investor needed to know for the past 40 years. However, there’s no way to be certain the next 40 years will behave the same.

New way

Since the dawn of the 21st century, equity investors have sat through deep stock market declines, one of about 48% and then another of 55%, after a moderate recovery. They have little to show for taking on that nail-biting risk — only an itty-bitty 12-year compound annualized return of barely one-half of one percent. The cautious, bond-allocated investors fared somewhat better with a compounded 3.56% return.

Perhaps we can take a leaf from Darwinian biology and attribute the generous 40-year stock returns for equities to the approach’s excellent fit with the investment landscape of the late 20th century. Yet, Darwinian biology teaches that landscapes are continually changing and good fits to one landscape are often not the best fit for a different environment. The investment landscape, like evolutionary landscapes, is changing constantly. An equity-only, or mostly equity, position also is a venture on the investment environment perpetuating the landscape. However, the prospect that the landscape has shifted is a real possibility. So, where does that leave investors?

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