When a new investor comes to me for advice about where to start, I tell them to start by getting familiar with the various asset classes that are available for trading. Stocks, bonds, commodities, Real Estate, Precious Metals, and so on.
Only when a new investor has a framework of how these asset classes perform, and how they influence each other, and how the economy influences their price trends, will he or she be ready to take the first step in setting up a balanced portfolio with a reasonable amount of diversification.
You can have too much diversification
Diversification is sometimes called the closest thing to a free lunch for an investor. I agree in principle, but diversification can be overdone. An over-diversified portfolio will produce mediocre returns, and that's not what I'm going for. I'm more interested in above-average returns, because I want my clients to reach their goals as quickly as possible, without taking unnecessary risk.
Diversification is a key concept, but you have to be smart about how you work it into your portfolio.
You can have not enough diversification
I run across way more investors who are under-diversified than over-diversified. The way this usually manifests is when they are particularly keen on a certain strategy, or trading system, or aspect of the market and they don't consider the possibility that their beloved approach can go out of favor, leaving them with losses that are greater than the market averages.
A little well-placed diversification can solve this problem, and it's not that hard to do.
The causes of over and under diversification
There are way, way too many choices available to an investor today. Thousands of mutual funds, thousands of ETFs, thousands of stocks and bonds, and niche assets like Bitcoin. How can a person who is holding down a full time job even begin to sort through all the choices that are out there?
The answer is that they can't. Maybe a trust fund baby or a dilettante could manage enough free hours to tackle this mountain of choices, but it would be really tough. So what's the answer? Asset classes.
Put everything else aside and focus on the main asset classes
Sifting through thousands of choices for where to put your money can be streamlined, if you have a process. Some people hate the idea of process, because it sounds so boring. But believe me when I tell you that without a defined process, you will be blown by the wind every which way and you will end up with mediocre results.
Let's dive into the asset class discussion.
For the purpose of this article, I've chosen four asset classes that have been around for ages and don't correlate very much with each other in terms of performance. This is a good place to begin, and I plan to do follow-up articles that dive even deeper into this topic.
For now, I'm going to talk about these four:
I'm aware that gold is a commodity, but gold bugs would disagree vehemently with that characterization. They see it as money, not a commodity. So I'm including it as a separate asset class. It doesn't correlate much with other commodities, and so it fits my purposes for this article.
One of the reasons I chose these 4 asset classes is that they all have ETFs with history going back at least as far as 2006. This makes comparisons easy, and relevant to what an investor can expect to earn.
I downloaded the relevant price information, and calculated how much a $1,000 initial investment in each asset class would have grown since October 2006. It's a simple comparison, and I don't advocate for one class over another.
Asset Class #1. Commodities
Let's start with commodities, the problem child of the capital market family. As you can see on the chart below, commodities have been in a funk since 2006. Does this mean you should shun them as an asset class? No! There are times when commodities rise up and lead the pack, so you don't want to miss out on that, now do you?
Furthermore, commodities have a very low correlation to stocks and other asset classes, which gives them the benefit of being a good diversifier.
I chose DJP to represent this asset class because it's broadly based and it's been around since 2006. You can see that an investor who put $1,000 into DJP in 2006 has lost 5.8% per year on average. Why are we even talking about an asset class with such a dismal record? Because of mean reversion. Commodities will one day return to their former glory. We just don't know when.
Asset Class #2. Gold
An investor who came of age in 2006 has done considerably better in gold than in broad commodities. I like gold, but only in small amounts. It's another non-correlated asset, which provides the benefit of diversification, but gold has also spent many years in the wilderness. Therefore, I recommend that my clients allocate no more than 5% of their money to gold.
As you see on the chart below, a gold investor has earned 5.4% per year since 2006, much better than the DJP investor.
Asset Class #3. Bonds
The folks who are the most satisfied with bonds as an asset class are the ones who started investing in the late 1970s. Bonds have been on an almost unbelievable run since then, and bond investors never miss an opportunity to rub their good fortune in the faces of stock investors.
But let's get real. We're looking at these asset classes from 2006, not 1979. On this time frame, bonds have delivered an annual return of 3.6%. And that includes the great spike in bond prices during and after the Global Financial Crisis in 2008.
So, to you bond aficionados out there, remember that the gold bugs made more bank than you did since 2006. Just sayin'.
Asset Class #4. Stocks
I've saved the best for last. I admit that I'm biased towards stocks, but can you blame me? Stocks, in the broadest measure I could find, have produced an annual return of 8.9% since 2006. And that includes the 50% market crash in 2008.
Let's face it, stocks are king and they always have been. But here's the point. Stocks are not a one-asset portfolio. Stocks sometimes stumble, badly. There are times when stocks are underwater for as long as 20 years. If you hitch your wagon to stocks, and don't have any other asset class in your portfolio, then you're in for a rough ride.
Asset allocation is extremely important for an investor. It's more important than picking great stocks, or market timing, or hitching your wagon to the latest fad. An investor who put $1,000 into each of these 4 asset class ETFs in 2006 would now have $6,492. That works out to a 4.2% compound annual growth rate.
Are you thinking that this is a bad result? Consider these facts:
- The volatility of this portfolio was 10%, versus 21% for an all stock portfolio.
- The best year was a gain of 18.7%.
- The worst year was a loss of 14.7% versus a loss of 38% for an all stock portfolio.
- The maximum drawdown for the period was 24.6%, versus 50% for an all stock portfolio.
- Finally, this portfolio had a 52% correlation to the stock market. Isn't that the point?
I ran the numbers without the commodities asset class, and the compound annual return was 11.4%. Fantastic, you say. But don't forget, one day it will be commodities that are leading the pack.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.