Yikes.
Two sharp falls in a row is enough to get any investor a little nervous. Yes, so far the Dow Jones Industrial Average’s DJIA back-to-back plummets are still only a tremor on any longer-term view. Stock prices are higher than they were even one year ago. Nonetheless for many investors it’s an overdue reminder that stock prices can fall — and fall a long way — as well as rise.
That makes it a good moment, say experts, to take stock of your portfolio. Are you taking on more risk than you want? Worse, are you taking on more than you realize? You may well be. And your financial adviser, if you have one, may not realize it either.
A ‘balanced’ portfolio of stocks and bonds failed previous generations of U.S. savers, and badly, during at least two extended periods during the past century alone.
Conventional wisdom says that a “balanced” portfolio of stocks and bonds will cushion you from shocks and make sure your savings keep growing in all markets. It’s the philosophy behind nearly all financial advice offered in America today, and one that’s taught in most finance courses.
It’s also the theory behind those “balanced” index funds, “target date” funds and “glide path” funds that try to offer you a one-stop portfolio. It’s also the theory behind the portfolios offered by most “robo advisers.”
There’s just one problem: History says it may be wrong.
A “balanced” portfolio of stocks and bonds failed previous generations of U.S. savers, and badly, during at least two extended periods during the past century alone, financial historians note.
Worse, those occasions had more than a passing resemblance to the situation today: Expensive stocks, expensive bonds, and concerns about rising interest rates and rising inflation.
Why some people have déjà vu
Here are the numbers. For an entire decade, from 1938 to 1948, a portfolio of 60% U.S. stocks and 40% U.S. Treasury bonds actually went backwards in relation to inflation. That’s based on data compiled by New York University’s Stern School of Business, as well as inflation data tracked by the U.S. Department of Labor.
Over that period, not only did savers not get rewarded for investing, they got penalized. Their portfolios lost purchasing power. Furthermore, that’s before taxes. If inflation is 5% and your portfolio rises 5%, you earned a zero “real” return but you are getting taxed as if you earned 5%.
The story was even worse 30 years later. Someone who bought a 60/40 portfolio in 1968 saw it lose nearly a third of its value over the next six years in real terms. They were still underwater 15 years later — an aeon when it comes to financial planning for college funds or retirement. Not until 1984 did they even get back to where they had been during the summer of love.
The 60/40 portfolio v. surging inflation
Both periods saw surging inflation. “The basic vulnerability of the 60/40 portfolio… is rising inflation,” warns Ben Inker, the head of asset allocation at money manager GMO in Boston. Stocks have traditionally struggled during periods of inflation, historical analysis has shown, while bonds have fared much worse.
Consumer inflation broke double-digits twice during the 1970s, hitting 14% in 1980. “Prices went up,” Inker notes, “and your portfolio went down.” It was, he added, a “nightmare” for many investors.
If ’quantitative easing’ and ‘zero interest rate policy’ caused stocks and bonds to rise, reversing those policies could bring them back down to Earth.
But inflation wasn’t the only thing shaking markets, historical observers note. These two periods also saw other unexpected shocks to the existing financial order. The 1940s saw the unprecedented global crisis of the Second World War, followed by skyrocketing U.S. government spending and debts. The 1970s saw periods of economic stagnation, rising interest rates and two damaging oil crises.
Today, inflation is, so far, reasonably tame. The official rate hit 2.9% over the summer but has since eased to 2.3%, which is mild by modern historical standards. But the Federal Reserve says it is concerned about pressures in the system that could erupt into surging prices.
Fed takes U.S. economy into unchartered waters
Meanwhile, the Fed is taking the economy into uncharted waters with its policy of “quantitative tightening.” For a decade, it kept interest rates artificially low and bought Treasury bonds to boost economic activity following the financial crisis. Now it is trying to reverse the policy. If “quantitative easing” and “zero interest rate policy” caused stocks and bonds to rise, say some analysts, reversing those policies could bring them back down to Earth. Nobody really knows.
Where does this leave the ordinary saver? Traders and active investors may see turmoil as opportunity. But for those who just want to invest and forget, is there an alternative to the 60/40 portfolio that may help you sleep easy?
“There is no such thing,” says Joachim Klement, head of investment research at investment firm Fidante. In today’s environment of “ultra-low interest rates and high valuations” any portfolio that is going to produce a reasonable return is going to take on a lot of risk, he warns. There aren’t simple panaceas, agrees GMO’s Inker. “There isn’t an obvious, here-is-the-better-thing, to do with your portfolio,” he says.
Lessons from ‘safe havens’ in the 1970s
During the inflationary 1970s, many investors added gold and other commodities, such as oil, to their portfolios. Both helped hedge against rising prices. Gold did not become freely tradable in the U.S. until the middle of the decade, when the federal government stopped linking it to the dollar. Gold then rose from $35 an ounce to more than $1,000 at one point. One mutual fund born out of the 1970s, The Permanent Portfolio, also includes real estate, natural resource stocks, and Swiss francs.
Some foreign stock markets, especially those of fast-growing, emerging markets at the time, such as Japan and Singapore, also helped investors beat the grimmer news at home. Data from stock market index company MSCI shows that during the 1970s, while its broader measure of US stock prices rose about 50% (before inflation), the Japanese stock index rose 400% and the Singaporean index even more.
This suggests emerging markets today might also help diversify your portfolio. Ironically, recently they have been in the eye of the storm, with many markets falling 20% or more. Some investors argue they are now looking good value.
What worked in the past may not work today
Hedge fund titan and Bridgewater head Ray Dalio has argued for including commodities and gold, alongside stocks and bonds, in what he calls an “all-weather portfolio.” Money manager Alex Shahidi added Treasury Inflation Protected Securities or TIPS, Treasury bonds issued by the U.S. Government that include specific inflation protection.
The late investment guru Harry Browne argued investors should keep one fourth of their money equally in stocks, bonds, cash and gold bullion.
The late investment guru Harry Browne argued investors should keep one fourth of their money equally in stocks, bonds, cash (or short-term Treasury bills) and gold bullion. These portfolios typically required nothing more than occasional rebalancing to maintain the original proportions.
These would have helped investors in the 1940s and 1970s, analysis has shown. The obvious caveat, say investment analysts, is that what worked in the past may not work again. (But that is also true of the 60/40 portfolio.)
Inker says GMO is now “making extensive use of liquid alternatives” in the portfolios it runs for clients. This includes hedge-fund type strategies such as bets on global interest rates, mergers and the like. Such strategies are not easily accessible to retail investors.
Gold is still a go-to diversifier
Gold and silver are not what they once were, as the U.S. government has long since broken its legal connection to the dollar. But they still have their adherents. Charles de Vaulx, widely-respected money manager at IVA funds, holds 5% of the IVA Worldwide fund in gold bullion as insurance against hyperinflation or crisis.
Gold, some contemporary analysis has shown, still retains some power as a diversifier because it frequently moves in price independently of stocks and bonds.
Fidante’s Klement argues that “senior bank loans,” consisting of credits to corporations, may be an appealing diversifier. They offer some protection against inflation and rising interest rates, he argues, because the loans are on floating rates. Inker warns that the creditors’ protections, in the form of covenants, are generally not as good as they were in the past.
Cash can still be king—sometimes
And then there is the simplest asset of all: Cash. This includes Treasury bills, money market funds, short-term Treasury bonds, and Certificates of Deposit. These assets typically have produced poor long-term returns, which one reason why they tend to be shunned on Wall Street (another is that they generate low fees).
But they are generally highly liquid, and easy to buy and sell. Their price doesn’t fall in market turmoil, and their interest rates will rise with the Fed’s. “The obvious thing that everyone knows about is cash,” says GMO’s Inker.
“There are times to sit on cash,” wrote investment legend Sir John Templeton. Not only did it not go down in a crash, he noted, but it then enabled you to take advantage of investment opportunities later on.
A study conducted on behalf of Cambridge University a decade ago recommended a long-term portfolio of 80% stocks and 20% cash. Warren Buffett, in his 2013 letter to investors, recommended a basic portfolio of 90% stocks and 10% short-term government bonds.
Cash need not be limited to U.S. dollars either. While the greenback has been on a tear lately, in the past investors have used other currencies, including the euro, the former deutsche mark, and the Swiss franc to diversify risks.
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