over 2 years ago • 4 mins
If you’re looking to hold investments for the medium term – about five years, say – then going all in on stocks might be a bit too risky. But throw in just two more assets, and you’ll build yourself a far more robust alternative portfolio – one that’s never lost money over any five year period.
There are a few good reasons stocks make up the core of most medium-term portfolios: they’ve historically generated high returns, there are plenty of cheap ETFs that track them, and they’re the asset class investors are most familiar with.
But while stocks do generate high returns on average, they’re highly volatile in the short term. Investors holding stocks for five years would’ve made returns ranging from -27% to 233%. And in the decade between 1995 and 2005, investors would’ve ended up back where they started after 5 years half of the time. Losses can be brutal too: stock investors would’ve lost more than 40% three times over the past fifty years.
So stocks might be a good starting point, but they’re too risky to go all in on. That’s why you’ll want to…
Stocks are driven by corporate earnings and investor sentiment, both of which rely on positive and stable economic growth. Thankfully, that’s the most common environment. But as the pandemic reminded us, there are some unforeseen events that can tip economies into recession – sometimes brutally. And when they do that, stocks do too.
So to build a more robust portfolio, we need to add an asset that performs well when the economy sours and stocks go down. So far, government bonds have fitted the bill. When the economy slows down, central banks generally cut rates to encourage borrowing and propel the economy back up. And since bond prices go up when rates go down, bonds tend to work pretty well in this environment.
That just leaves one more issue to deal with…
We’ve added bonds, but there’s still one factor that threatens our portfolio: inflation. High inflation is bad for both bonds and equities because it lowers the “real returns” investors effectively get when investing in them.
To protect our portfolio against inflation, we should add an asset that performs well in highly inflationary environments – an asset like gold. Since gold is a physical asset and its supply – unlike traditional currencies – can’t easily be topped up, it should preserve its value in real terms if inflation spikes.
So to compare how our new portfolio would fare against just holding equities, I ran a backtest comparing a portfolio of 50% US stocks, 25% 10 years US government bonds and 25% gold to a portfolio of 10% US stocks. Let’s see what the numbers say…
Adding gold and bonds would’ve cut the five biggest losses by half and reduced the maximum loss to just 21%. And while stocks twice lost money over a 5-year period, the balanced portfolio didn’t – and its worst return over 5 years was an impressive 7.5%.
While stocks generated 10.8% a year, the balanced portfolio did almost as well at 10.2%. But there’s a caveat: it did as well on average, but it underperformed quite significantly when stocks experienced strong bull markets, like in the late 1990s and over the past 10 years. So cutting the downside risks comes at the expense of overperforming when things are rosy. But all in all, the reduction in risk more than offsets the reduction in return, and the balanced portfolio displays better risk-adjusted returns: the sharpe ratio (i.e. returns divided by volatility) goes up from 0.45 to 0.58, and the average gain over average loss jumps from 1.03 to 1.2.
The balanced portfolio certainly isn’t perfect, and you may even disagree with the components or the weightings. But it's not a bad starting point for building a more robust portfolio.
Yes, bonds are expensive, but so are stocks. And no, gold prices won’t go up forever, but nor will the economic recovery. In such an uncertain environment, you have everything to gain from spreading your risk. Should stocks collapse, the Fed comes to the rescue and bonds and gold might save the day. Should the recovery intensify, stocks win big.
So this is one way you can benefit from diversifying beyond just stocks. But it’s not the only way, and you ought to get your hands dirty with tools like Portfolio Visualizer to test different assets, weightings, and holding periods. At the end of the day, after all, the very best portfolio is the one that meets your own objectives.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.