Investing Tip #1: Diversification, Part One

When all you have is a hammer, everything looks like a nail, or so the saying goes.  My dad and I have spent the last couple Saturdays building a playhouse/swing set for my girls.  I couldn’t imagine building it using just a hammer.  Even an accomplished carpenter (which I certainly am not) would have some difficulty with that.  I’ve found myself using many different tools, including a screwdriver, rule, circular saw, and level. 

If we think of different investments such as stocks and bonds as tools, it becomes obvious that successful investing requires that we use more than one tool as well. 

In my practice, I insist on my clients owning at least four tools or asset classes:  stocks, bonds, real estate, and commodities.  Just like a hammer or screwdriver, each has their job in a portfolio. 

1. Stocks do best when the economy is growing.  In boom times like the 1990’s, they will leave every other asset class in the dust.
2. Bonds do best when the economy is in recession.  I should clarify—I’m referring to high grade bonds such as U.S. Treasury bonds here.  Low grade or junk bonds tend to move with the stock market.  Bonds did great during the tech bubble and subsequent recession in 2001, and also during the Great Recession of 2008.
3. Real Estate does best when inflation is high and when obtaining loans are easy.  Real Estate did great during the inflationary 1970s, and we all remember the housing boom of the early 2000s.
4. The commodities that I focus on are precious metals, especially gold.  Gold does best in times of political and economic instability.  A recent horrific example would be last week on July 17th when the Malaysian airliner was shot down in Ukraine.  Gold, represented by the Gold SPDR ETF jumped 1.3 percent while the Dow Jones Industrial Average lost 161 points (-0.9 percent).

So how does a four asset class portfolio compare to the stock or bond markets?

Below I’ve charted the returns for bonds, stocks, and a portfolio of all four asset classes from 1973 through 2013. 

The blue columns represent the average annual return for each and the red columns represent the worst annual loss for each.  

Source:  Author calculations using Morningstar Hypotheticals and iShares Asset Class Illustrator

Having all four “tools” in the toolbox gives you 96% of the return as stocks over time, but with 43% less risk, as measured by standard deviation. 

If you invested all your money in stocks, your worst one-year return would be 11 percentage points worse than if you had your money invested in a portfolio of stocks, bonds, real estate, and commodities. 

Just as important, the stock market endured nine negative years since 1973.  The diversified portfolio only had five.  

Of course, past performance is no guarantee of future results, so this may not hold true in the future.  But, it just makes sense that spreading your money among different asset classes should reduce your risk over the long term.