Stocks are one of the most popular asset classes in the investment world. They have the potential to generate both cash flow and capital appreciation. However, it is also wise to diversify away from stocks by looking at other asset classes.
Content
- Introduction
- Historical Return Numbers
- Big Stock Market Drops
- Long Periods with Low Returns
- Examples of Large Stock Crashes
- How to Diversify Away from Stocks
Introduction
Stocks are an asset class that responds positively to economic growth and a balanced monetary policy. If there a solid legal framework and open capital markets, stocks can do very well. Nevertheless, no asset class is by itself a panacea. Not even the stock market.
The need to diversify away from stocks means they should be combined with other asset classes. Diversification is key for long-term investing. There two main reasons why want to consider that:
On the one hand, we can never be absolutely certain that conditions that are conducive to positive stock performance will exist in the future. Therefore, we must be prepared for alternative scenarios.
On the other hand, the stock market can be subject to large fluctuations, including bubbles. If we have the misfortune to enter when stocks are very expensive, and they start to drop afterwards, we will suffer great losses and not have any dry powder to take advantage of the discounts.
And because it is very difficult to know if we are in the middle of a bubble, or if stocks are about to correct heavily, it is just better to be prepared for all eventualities.
Historical Return Numbers
A potent argument to convince us of the need to diversify away from stocks is to look at some historical returns. We will focus on the most important stock market indices of three of the world’s largest economies, representative of three different continents: the United States, Japan and Germany.
We will analyze the returns of those three indices over the last 5 decades. Returns shown are annualized, in local currency, and consider dividends paid. This means they are total return figures, consider both dividend payments and price appreciation.
In order to judge whether those returns are good or bad, we can compare them with the annualized inflation rate in each of these countries throughout these 5 decades. Green indicates positive real returns, where the stock market’s return was higher than inflation, red indicates negative real returns if there has been a loss of real purchasing power, and yellow real returns hovering 0%.
We also see the annualized price change of gold in US Dollars in each of the last 5 decades:
We can draw several conclusions from looking at the data in the table:
First, it is worth diversifying internationally. Even though markets are more correlated today than in the past, returns vary by geography. By investing in different regions, we increase the likelihood of achieving positive real returns and are less exposed to extremely adverse scenarios.
Second, inflation has to be considered if we invest for the long term. Achieving positive nominal returns by itself is not enough. If the inflation rate is higher than the return we obtained, the real investment return is negative, and we have lost purchasing power. At the same time, remember that official inflation figures are sometimes lower than the actual rate of inflation. So, if anything, the inflation indicated in the table above understates inflation.
Third, and most importantly: gold offers incredible diversification. The decade of the 1970s, which was quite negative for stocks, saw gold rise at an annualized rate of 34%. Yes, 34% per year. The first decade of the 21st century was also very strong for gold, returning almost 15% per year. Conversely, the poor performance of the precious metal in the 1980s and 1990s is offset by strong stock market returns.
As you can see, it makes sense to be well diversified across asset classes. If stocks are weak, gold is likely to be very strong. And if gold is weak, stocks are likely to perform very well. Since we cannot anticipate what will happen, it is a good idea to own both asset classes.
Big Stock Market Drops
Another reason why it is advisable to diversify away from stocks is to better withstand big market drops. In hindsight, it is very easy to say we should simply sit out bear markets and be patient. A weak stock market can see very large price drops and be very prolonged. In fact, there is no guarantee things will recover to the same degree.
Although it is usually a good idea to dollar cost average, that is, buy regularly at different times, that will not save us from market crashes. If we have been investing on a monthly basis for 5 years and there is a major crash, we will experience heavy losses and it will take time for us to recover.
Owning assets capable to withstand difficult macroeconomic scenarios, or even profit from them, is key. On the one hand, they will make sure we are able to manage our emotions. On the other hand, they can be the dry powder we want when stocks are trading at a discount.
In the following section you will find a table with some of the biggest historical drops of the S&P 500 index.
Long Periods with Low Returns
Because of the potential large drops that may occur from time to time in the stock market, there is a high probability that we will eventually experience a long period of poor performance.
If we combine a stock market crash with a relatively slow recovery, we may have to wait several years until we get back to where we were prior to the crash. And if we take into account inflation, the waiting period can be even longer.
However, thanks to diversification, other assets may shield our portfolio during a stock market crash. This will make it possible for us to benefit from it and be in position to acquire equities that are trading at very low prices.
Examples of Large Stock Crashes
The following table shows some of the biggest historical declines of the S&P 500, and the time it took to recover to the pre-crash levels:
As you can see, market crashes can be very deep, exceeding 50% in some situations. And it can take close to a decade or even longer to recover those losses at a nominal level.
In fact, if you look at the data in the table you will see that the recovery from the crash that began in March 2000 was only completed in May 2007. However, in October 2007, the stock market crash related to the 2008 financial crisis began, and those levels were not seen again until 2013.
Consequently, the levels seen in the S&P 500 in early 2000 were only recovered in early 2013. And this does not consider the inflation or even the emotional stress experienced during that long period.
Something similar could be said about the crash experienced in the 1970s which saw the market go down by almost 50%. Even though the recovery was completed seven and a half years later, that was during a period with an average of 8% annual inflation. Adjusted for inflation, the 1973 peak in the stock market was not seen until the mid-1980s.
Had we owned other assets in our portfolio during those years, we would have done much better.
How to Diversify Away from Stocks
The optimum outcome when we add diversification to our portfolio is to reduce the overall level of risk, while still maintaining strong return potential.
Risk is usually measured by volatility. Volatility explains how much an asset moves. Investors prefer an asset that goes up over time in steady fashion over one that is rallying and crashing on a regular basis. However, volatility is not everything.
Another important risk measure is the maximum drawdowns, or maximum losses experienced. Since the stock market can perfectly crash 50% over a relatively short period of time, we probably never want to be in a position where half our wealth could be subject to that outcome.
By owning different assets in our investment portfolio, we reduce volatility and the size of potential market crashes. In addition, if all assets we own have positive expected returns, the potential return for the overall portfolio remains high.
In my opinion, a portfolio should have stocks from all over the world, both developed and emerging markets, gold, commodities, cash, and some bonds.
Outside our financial portfolio, and as part of the diversification process, real estate is also an asset that we should consider. Some of the best features about real estate is that it is the only asset that allows us to use debt cheaply and safely, and the only one that can provide shelter.
If you are interested in building a diversified portfolio with a few single steps, check out this links:
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