The continuum of possibilities within the world of investments has two axes: reward and risk. In virtually all cases, as the potential for reward increases, so does the exposure to risk. For the great majority of portfolios, the key constituents are stocks and bonds. Each of the major asset classes is subdivided into many smaller segments.
Stocks can be divided into domestic and international. Within each of those categories, they can be further divided by the size of the companies they represent. Of those that are international, the countries may be labeled developed or emerging. To make things more confusing, there are companies such as Coca-Cola or 3M that are ostensibly domestic, but in fact derive most of their revenues from outside the U.S. The converse would be Royal Dutch Petroleum and Nestle, based abroad, but with a considerable presence in North America.
One of the most basic rules of thumb is that over extended periods of time, generally 20 years or more, stocks have always outperformed bonds. Indeed, over the last nine decades, their average yearly return has been about 10%.
By comparison, bond returns have been closer to 5%. So if stocks return twice as much as bonds, why not invest only in stocks? The answer is that although the average return was 10%, there have been years when stocks have lost 20% to 30% or more. For that matter, there have been decades, such as 2000-2010, when the overall return from stocks marked time.
Bonds are more stable, but they too have roller-coaster periods, such as 1974, when a sharp rise in interest rates wreaked havoc with bond prices, leading to interim principal losses of 20% or more on those with long maturities. With bonds, however, the losses disappear if the bonds are held to maturity.
One of the ifs in this equation is that the losses will not disappear if the bonds need to be sold prior to maturity. The other relates to the strength of the companies issuing the bonds. An issuer having difficulty meeting its obligations may be unable to redeem its bonds at maturity, i.e., default. Or it may not be able to meet periodic interest payments. Just because a security is called a bond does not mean it is without risk.
Within the spectrum of stocks, there are large capitalizations (shares times market price), companies such as Amazon, Microsoft, and Apple, and small caps, companies whose names few people will recognize. Over time, small caps have outperformed large caps, but, not surprisingly, they have been considerably more volatile. What’s more, during periods of unusual market weakness, they tend to be compressed to levels that bear little, if any, relation to their underlying earning power or value of their assets. But in the rebounds that follow, they often outperform their larger brethren by a wide margin.
Moving out of the mainstream, one finds such things as real estate investment trusts, energy trusts, managed futures, currency hedge funds, arbitrage funds, covered call funds, as well as a variety of even more esoteric opportunities that have their own pluses and minuses.
As the search for an even broader range of investment possibilities continues, it becomes clear that no one asset class (or subclass) offers an optimal balance of reward and risk. In this quest, the goal is to capture above average returns while exposing one’s assets to a proportionately lower level of risk. With individual asset classes, it is accurate to believe that higher returns will be accompanied by higher risk. As more asset classes are added to the mix, however, one can retain much of the potential for gain while markedly reducing the exposure to loss.
The risk variation across the spectrum of asset classes is considerable. Emerging markets stocks have generated the highest long-term, average annual returns, but their interim fluctuations have been about seven times as high as those of investment grade bonds. At the same time, there have been several other asset classes that have done almost as well, but with considerably greater stability. Value stocks, for example, captured about two-thirds of the returns generated by emerging markets stocks, but their volatility has been less than half.
These findings lead to the suggestion that participation in all the key asset classes will provide a better balance overall. Why? Because with few exceptions, asset class returns over time have tended to move independently of one another. It is true that in recent years there has been an increased correlation among those returns, but a distinct difference still remains.
The bottom line is that a well-conceived combination of asset classes will strengthen the portfolio both in terms of potential reward and risk abatement. Thus, we end up with a fabric that is considerably stronger than any of the threads woven into it.
N. Russell Wayne, CFP®