Published July 26, 2012
Positioning your investment portfolio with fewer stocks and bonds may go a long way toward lowering risk and increasing your return.
I recently heard the Canadian Finance Minister, Jim Flaherty, talking about diversification within their state pension fund. He said it was their goal to have investments in the capital markets (stocks and bonds) equal approximately 45% of the total pension value. He went on to say the capital markets are mostly needed for liquidity and not relied on for growth. Investors have many choices to compliment their stocks and bonds. Investing more in real estate, commodities, metals, insurance, and currencies can add growth, safety, and more diversity.
In microeconomics a family has limited recourses when deciding how to allocate or spread their money into many diversified baskets. They can choose between stocks and bonds or food and energy. Some prudent investors choose both.
In macroeconomics, the guns versus butter model is an example of a nation that has to choose among three options when spending its finite resources. It can buy guns (invest in defense/military), butter (invest in production of goods), or a combination of both.
Like a nation or a free economy deciding how to best use its limited resources efficiently, a family must be careful not to invest its own limited assets in too few baskets. I understand how elementary that statement is. However true diversification is terribly misunderstood.
A simple example of true diversification being misunderstood is mutual funds. If you own five mutual funds, each holding 100 stocks, you may feel comfortable because your money is spread among 500 stocks. Is that diversification? All five of those funds most likely own many of the same stock companies. It’s called crossover when you have Wal-Mart, Coca Cola, General Electric, Exxon, and many other of the same stock companies in all five of your mutual funds. This is easy to check before you purchase mutual funds. However few financial advisors do it and fewer investors too.
Stocks are not the only problem, bonds may be worse. Owning bonds can be like owning ten CDs at ten different banks. Are you diversified? You still only own CDs. What about all the other asset classes available for proper diversification in your portfolio? Are they equally discussed when making investing decisions?
I would like ask the question, why you do not own food and energy as one easy way to increase diversification? The answer, most likely, is because brokers and advisors get paid to sell stocks and bonds. Having staples that people have to consume in your portfolio is quite easy to do, as easy as buying an S&P 500 Index fund.
No one knows how well stocks and bonds will perform in the future. We do know that in the coming years, consumers and industries will continue to demand corn, wheat, soybeans, sugar, coffee, cocoa, hogs, cattle, gasoline, natural gas, crude oil, heating oil, industrial metals like high grade copper and silver, plus much more. Although any investment is price sensitive, having assets that represent the tangible ownership of commodities is attractive and may become much more attractive in the future. Given the long time that will be required to improve the world’s debt level, this does not create the best environment for stocks and bonds.
You can easily add to your portfolio a mixed indexed basket of these everyday commodities through an Index. True diversification comes from owning assets whose performance is completely unrelated to each other. They are non-correlated investments. Their price movement is unrelated. Food, energy, and metals, are items that are consumed and used everyday. They will be sold no matter what the stock market does on any day. People have to eat every day; they do not have to buy bank stocks or housing stocks. When putting your limited investment dollars to work, remember true diversification includes many different asset classes.
Over the last decade and also the last two decades the S&P 500 index was out-paced by most commodities. The Trader Vic Index (TVI) is a good example of a breadbasket index. It has been back-tested to 1990 to see how it specifically would have compared to the S&P 500. First, starting 1/1/ 2000 through 2011, a $100,000 investment would have grown to $198,211 verses the S&P 500 which a $100,000 investment lost ground to $87,580 according the daily historical prices listed on Yahoo Finance.
Compare the same two indexes from 1990 to 2011 and they are a little closer. In the TVI, the same $100,000 would have grown to $353,356 by the end of 2011. The S&P 500 was close by the end of 2011: $100,000 would have grown to $324,789, only an 8.79% spread or $28,575 less, but more importantly with a fraction of the volatile price swings the S&P 500 had during this time.
The S&P 500 had 6 years of losses and the largest was -39.7% in 2008. Also between 2000 and 2003 it dropped -43.12%; it can take years to recover big losses. The TVI from 1990 had 3 losing years of -2.15%, -.55%, and -8.97%. The stock market and food and energy are non-correlating. It is correct diversification to have asset classes that their prices do not move in the same direction at the same time.
Note one interesting fact: from 1995 to the end of 1999 the S&P 500 increased by 196.43%. Is that going to happen again during the next fifteen or twenty years? That obviously made a big difference. If during those five years, the S&P 500 had earned 10% per year, the $100,000 would have grown to only $165,054 instead of the $324,791.
In macro and micro economics, opportunity cost is defined as the cost to you for investing in item A and missing out on the benefit offered by item B. What percentage of a portfolio should be in food and energy verses stocks and bonds? The answer is not carved in stone and will depend on your unique situation. However, even a very modest position in recent years would have added an increased value to your normal portfolio mix and less risk.
For more information on diversifying your portfolio and preparing your finances for the future, contact Jim Wilson from Wilson Investment Group at (918) 610-7771 or email@example.com
All amounts and percentage returns were provided by the historical daily pricing offered by Yahoo Finance and the Trader Vic Index back-testing data.
Securities offered through SICOR Securities, Inc., a registered Broker/Dealer, member FINRA, SIPC, MSRB. Wilson Investment Group and SICOR Securities, Inc are unaffiliated