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.
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?
First, recognize that equities are only one asset class (add bonds and we are at two asset classes) among a variety of potential investment vehicles. Some of those other designs may prove better suited to other investment environments, such as long periods of escalating inflation or a rambunctious property market, both of which periodically emerge in our economy and could be among the qualities that distinguish the next 40 years.
While only hindsight is 20-20, today’s equity investors owe it to themselves to explore new ways to diversify their portfolios. Perhaps the new guidelines will extend beyond traditional equity classes, such as technology, international funds and small-cap holdings.
To that end, we’ll examine adding two additional asset classes to a traditional equity-based portfolio:
- Precious metals, specifically gold: Gold has a design that enables it to respond positively (increase in value) when inflation starts becoming embedded in the economy, and also when leading governments appear to have lost the discipline to keep additions to their paper (fiat) money creation within bounds. While anecdotally we know this is true over the last 12 years (see “Jump on the bandwagon,” below), more in-depth analysis shows these periods will occur sporadically.
- Real Estate Investment Trusts (REITS): These offer an investment vehicle to take advantage of a property market on a tear.
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.
More recently, since 2009, the S&P 500 has suffered two double-digit losses based on month-end figures. In late spring 2010, the S&P fell by 12.71%. Next, from month-end April 2011 to the end of September 2011, the S&P dropped 16.22%. During both of those unsettling times, 4-AC maintained its low-risk profile, losing only 1.88% during the 2012 sell-off and dropping just 0.14% during the 2012 spill. Although it lost money, it fared far better than equities only.
If we break the entire 40-year (1972-2011) period into 38 three-year holding time spans (that is, 1972-74, 1973-75, etc.), we’ll see that the S&P 500 suffered eight negative three-year holding periods and three in excess of 20%. The worst was a loss of 37.61% from 2000 to 2002. However, 4-AC does not have a single negative three-year return. Its lowest three-year total return was an 11.81% gain from 2007-09. “Year-by-year returns” (below) shows the annual data, cumulative growth and the three-year returns for the S&P and 4-AC portfolios.
Investors, if they wish, certainly are free to introduce some flexibility into the mix. Indeed, re-assessing your personal goals, and your path to those goals, is advisable for even the most hands-off investors. For example, with respect to 4-AC, it may make sense to ramp up the S&P 500 allocation to, say, 30% while reducing one of the other classes by five percentage points. You might do this based on a changing personal financial picture or your personal assessment of broad economic trends.
Investors also could invest a portion of their stock allocation into emerging markets or the Nasdaq. Likewise, a bit of the bond portion could be switched to five- or 10-year Treasury notes. However, these moves are just fine-tuning. None of them would affect the outcome much over the long term.
The ultimate lesson may be that investing well in a shifting financial landscape requires delving into areas that provide further diversification to the traditional investment classes of stocks and bonds. Perhaps 4-AC, because it exposes you not only to different asset classes but also to more opportunities to adjust and fit the investment balance to the prevailing investment climate, is the better answer for portfolio diversification in today’s financial marketplace.
Dick Stoken is president of Strategic Capital Management and author of “Survival of the Fittest for Investors.”