From the February 2013 issue of Futures Magazine • Subscribe!

Diversification for a brave new world

To test the viability of these investments, we’ll create a portfolio (4-AC) that includes four asset classes: 1) the S&P 500, the proxy for a basket of stocks; 2) long-term 20-year Treasuries; 3) gold; and 4) REITS. We will balance them equally at 25% each. At the end of each calendar year, we’ll rebalance back to 25%. Although our goal is to develop a portfolio that will work well going forward, we’ll begin our analysis by looking backward; after all, historical data is the only data on hand. Summary results for the past 40 years are shown in “Three portfolios” (below).

The 4-AC portfolio beat both traditional portfolios handily. Its total 40-year return was about 75% greater than a straight S&P 500 portfolio, while it more than doubled the 60/40 portfolio’s total return.

The frosting on the cake was a much more attractive risk profile. A standard deviation of 10.03% is 45% less than the standalone S&P 500 portfolio’s and 12% below the 60/40 portfolio’s. There is another way to measure risk. We simply can add up all the negative calendar years and divide by the number of years observed (in our case 40) to get an average loss value. Figured this way, 4-AC’s average loss of (0.59%) is 82% less than the standalone S&P 500 portfolio’s, and 57% below the 60/40 portfolio’s. By both measures, the more diversified portfolio is superior in terms of risk.

An argument could be made that the full 40-year period is biased toward the traditional portfolios. After all, we already know stocks, especially, have done quite well as a passive investment over that period. Although a more recent period is obviously more limited in its scope and, therefore, significance, it may provide an additional clue toward 4-AC’s value in a new investing environment.

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