Are Stocks and Bonds Really the Only Assets You Need in Your Portfolio?

With the bull market in stocks that began in 2009 (1982 if you consider the longer-term super bull market), it’s common for investors to hold portfolios consisting entirely of stocks and bonds. But are stocks and bonds really the only assets you need in your portfolio?

It may seem that way now, but a deeper look at investing history tells a very different story. That shouldn’t be surprising. Investors have a notoriously short memory, and routinely place exaggerated faith in the events of the most current market cycle. By that measure, being entirely invested in stocks and bonds seems perfectly logical. Some investors and investment advisors even make the bold claim that you should be 100% invested in stocks!

So it is when bull markets are riding high. But with the stock market setting new records almost every week, let’s dare to take a contrary opinion. After all, it’s when markets reach extreme levels that long-term changes take place. Let’s consider the possibility it before becomes an obvious issue.

And while there’s still time to make needed changes in your portfolio.

STOCKS AND BONDS – THE DARLINGS OF THE FINANCIAL INDUSTRY

Consult with an investment or financial advisor, or move money into a robo-advisor account, and you’ll get a portfolio that consists primarily of two assets – stocks and bonds.

It’s generally assumed that the two will provide all the diversification and growth needed. It’s an article of faith that when one is down, the other will be up. That certainly proved to be the case up until the 1970s. Stocks grew during times of economic expansion, while bonds held their value during recessions and through stock market declines.

Interest income provided by the bonds, as well as dividend income from stocks, supplied a continuous cash flow enabling investors to weather a market decline. And when the market bottom was reached, and stocks began an upward march, the investor could sell off bonds and increase stock positions for the new cycle.

Perfect. Except for one thing: the diversification concept that worked so well unraveled in the 1970s.

That was the decade when both stocks and bonds performed poorly at the same time. As inflation accelerated, interest rates increased. Bond prices fell, and stock prices stagnated throughout the decade. An investor who began the decade with a mix of just stocks and bonds underperformed in the face of consistent inflation.

It was the decade when theory met its match in reality.

The situation has continued ever since. The pattern repeated in the 1980s, and in each decade after. As interest rates declined in the 1980s, both stocks and bonds saw major gains in price. The same thing happened in the 1990s. It was clear that stocks and bonds were no longer mutually exclusive investments – rather, they were tracking one another.

The era was marked by falling or stable interest rates that benefited both stocks and bonds at the same time.

STOCKS AND BONDS DON’T WORK IN ALL MARKETS

The merits of a stock and bond only portfolio are largely based on statistics. The thinking is that as long as you buy-and-hold no matter what, the law of averages will work in your favor, and you’ll come out ahead.

In that regard, investment professionals love to cite the statistically valid claim that the S&P 500 has averaged about 10% per year since 1928. If you can reliably average 10% per year, they reason, then all you need to do is keep your money exactly where it is.

The basic flaw in this reasoning is that you’re not going to get 10% in stocks every year. You won’t even get it in most years. It’s even possible that you’ll get substantially less over several years. In fact, the whole idea is rooted in a play on statistics.

More specifically, though the S&P 500 may in fact have produced average returns of 10% per year, it isn’t indicative of future performance, nor of the performance of stocks in any given timeframe.

Here’s another set of statistics that should never be ignored: the performance of the stock market varies dramatically from one decade to the next. Marketwatch disclosed the decade-by-decade performance of the market between 1930 and 2009, a timeframe covering about 80 years.

Here’s what they reported when looking at the performance of the S&P 500 in each decade:

• 1930 – 1939: – .1%
• 1940 – 1949: 9.2%
• 1950 – 1959: 19.4%
• 1960 – 1969: 7.8%
• 1970 – 1979: 5.9%
• 1980 – 1989: 17.5%
• 1990 – 1999: 18.2%
• 2000 – 2009: -.9%
• 1930 – 2009: 9.7%

When presented in this manner, statistics do support an average annual return of about 10%. But it’s clear that this is a combination of both good decades and bad ones.

THINKING OUTSIDE THE INVESTMENT BOX

Notice that in the decade statistics presented above, there are at least two decades in which the average annual rate of return on the S&P 500 was negative. In addition, the decade of the 1970s produced an average annual rate of return that was below the rate of inflation. Other investments, such as real estate, commodities, and especially energy and gold, easily outperformed stocks during that decade.

Further, notice that of the eight decades presented, only three provided returns that exceeded 10% per year. The other five decades were below, and often well below. Even the much-hallowed decade of the 1960s turned in an average performance well below 10%.

This is significant. The 10% annual average return is heavily skewed by the three decades in which the S&P 500 produce well above 10% annual returns. The 10% average over 80 years is completely the result of market performance in just 30 of those years.

This is the point dismissed by financial advisors (or intentionally ignored). If you happen to be investing in one of the more frequent decades when returns have been well below 10% – or even negative – the entire 10% argument will be meaningless.

This is why it’s so important for investors to think beyond just stocks and bonds. If we look just at the decade of the 1970s, we see that the 5.9% average annual return on the S&P 500 was a small fraction of the average annual return of 30.8% for gold during the same decade.

It can be said with some certainty that a portfolio consisting of just stocks and bonds would’ve been inadequately diversified in the 1970s. Even a small position in gold would have increased returns dramatically.

ADDING TRUE DIVERSIFICATION TO YOUR PORTFLOLIO

In order to be truly diversified, an investment portfolio needs to have more than just stocks and bonds. As we’ve just seen, gold was the most successful investment during the 1970s, easily outpacing stocks. Real estate would be another example.

And that’s the point. To be truly diversified, a portfolio should consist of stocks and bonds and precious metals and real estate and even some intelligent speculations.

This means that to be truly diversified, your portfolio needs to include positions in gold, silver, real estate (generally through real estate investment trusts, or REITs), and various speculations that have the potential to outperform traditional investments, particularly in unstable or declining markets.

Most people recoil at the idea of investing in speculation. In truth, most investors are already heavily invested in speculations. It may even be accurate to say that most investors are over invested in speculations.

Here’s why…

Consider growth stocks. They typically pay no dividends. Some of them don’t even have positive earnings. Many are trend stocks, which means that their price appreciation is primarily the result of their popularity with investors. The investment community frequently embraces such stocks, often due to the fact that the companies behind them are engaged in a popular business activity. The company may not even be turning a profit.

It’s speculation to be sure, but most investors don’t consider a stock to be a speculation when it’s popular with the herd. Yet it’s still a speculation in the truest sense.

So if you’re willing to speculate in stocks, you should consider more obvious speculations. That doesn’t mean that you need to move your portfolio over into these speculations wholesale. But it does mean that they should be represented in your portfolio.

ADDING PRECIOUS METALS AND CURRENCIES FOR DIVERSIFICATION AND SPECULATION

What many investors miss is that precious metals and even currencies can be important countercyclical investments. Either can outperform stocks during times of turbulence.

We saw that happen with gold during the 1970s, and then again in the early 2000’s. Both decades were marked by long bouts of domestic and global economic and financial instability. Gold performed exceedingly well in both environments.

Currencies represent another underappreciated diversification and speculation. We’re not talking about the major currencies here. Those tend to run in lockstep with the US dollar, and are more frequently traded for price arbitrage than any sort of long-term appreciation.

That’s more likely to happen with so-called exotic currencies. These are currencies like the Iraqi Dinar, the Vietnamese dong and other thinly traded currencies.

The reason why they represent true diversification is because of the potential to move independently of the major global currencies. For example, global instability often brings about major changes in currency valuations. Resource rich countries, such as Iraq, stand to benefit in those markets. Currencies of such countries could represent plays on certain commodities, such as oil.

They may even be a play on international diversification. During periods of turbulence, when economic fortunes in the developed countries are declining, wealthy individuals and international capital often gravitate toward specialized countries. This is already happening in Vietnam, which has become a magnet for international capital. Those trends tend to accelerate during times of economic turbulence, when money and industries are looking for geographic diversification.

The point is, holding a small amount of your portfolio in counter cyclical investments, like gold and silver, and exotic currencies can cover weaknesses in the stock and bond portions of your portfolio. It makes sense to hold positions in each, particularly since we now seem to be at the peak of the current financial cycle.

Will you’re portfolio be ready when circumstances change?