Asset Classes: Flying High in the Sky, Looking for Opportunities in 2015 by Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

It’s the start of a new year, meaning it’s also time to give your portfolio a tune up and ensure that its engine is running optimally and ready for takeoff. Soaring at 500 miles per hour and looking down from 40,000 feet at your portfolio, you can more easily visualize where you need to diversify and rebalance.

There may be no one more qualified to help guide you in this exercise than investor behaviorist and asset allocation guru Roger Gibson.

Some of you might have heard of or read the work of Gibson, whose seminal piece, “The Rewards of Multiple-Asset-Class Investing,” is still often cited as one of the best sources on the subject of building a killer portfolio. Though originally published in 1998, its main thesis—that a portfolio made up of multiple asset classes to minimize volatility and capture risk-adjusted reward—is as relevant today as it was 17 years ago.

Before I deep dive into the minutiae of Gibson’s piece, I want to share with you a chart last seen in an early December Frank Talk.

asset classes

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Using data collected between 1950 and 2013, we can see that the returns of a portfolio composed strictly of stocks have greatly outperformed those of bonds and a blended portfolio in the short term, or one-year period. The risks, on the other hand, have also far exceeded the other two scenarios, by a spread of at least 22 percentage points: stocks’ -37 percent versus a blended portfolio’s -15 percent.

But when blended portfolios were held for five, 10 and 20 years, they began to do two curious things: 1) they gradually outperformed bonds, and 2) they demonstrated less risk than stocks. In other words, it smoothed out the ride and prevented hitting turbulence along the way.

That’s why savvy investors know to be patient with their holdings and not easily give in to the prevailing culture of instant gratification. I’ve run multiple marathons over the years and am intimately familiar with the personal rewards of going the distance. A similar investing strategy can come with the same rewards.

The chart shown above illustrates what Gibson asserts early on in “Multiple-Asset-Class Investing”:

When we construct an investment portfolio using multiple asset classes, we discover that portfolio volatility is less than the weighted average of the volatility levels of its components.

In other words, stocks and bonds both have their own unique DNA of volatility, but when equally combined, the two have tended to balance each other out favorably.

As Gibson colorfully puts it:

The multiple-asset class strategy is a tortoise-and-hare story. Over any one-year, three-year or ten-year period, the race will probably be led by one of the component single-asset classes. The leader will, of course, attract the attention. The tortoise never runs as fast as many of the hares around it. But it does run faster on average than the majority of its components, a fact that becomes lost due to the attention-getting pace of different lead rabbits during various legs of the race…

Yet the tortoise, in the long run, leaves the pack behind.

And in case the analogy was lost on anyone, the hare is the single-asset-class—domestic stocks, for instance—whereas the multiple-asset-class is the tortoise.

This is precisely the point I make in my story, “A Little Pillow Talk Turned Her Husband on to Bonds.” To give you the Cliff Notes version, Karen, 64 years old and retired, convinces her husband George, 67, to allocate half of their retirement portfolio to domestic stocks, the other half to bonds. As a result:

What would have been restless nights for George through [the early 2000s] were moderated by the effect of the short-term muni fund Karen chose. And the great leaps in the S&P 500 that Karen would have missed out on were captured by her husband’s 50-percent allocation.

asset classes

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This hypothetical portfolio illustrates how diversifying into even just two asset classes—our Near-Term Tax Free Fund (NEARX) and an S&P 500 index fund, for instance—can result in less volatility. We can’t guarantee how our fund will perform in the future, but NEARX has historically shown an ability to dodge the dramatic swings and volatility in the equity market, similar to the ones we experienced during the first decade of the century. Of course there will be times when equities like an S&P 500 index fund will strongly outperform the 50/50 allocation to the S&P and NEARX combo, but George and Karen’s story is one example of how these two investment strategies have previously performed.

And speaking of municipal bonds, the Wall Street Journal reports that they’ve had their best year in approximately two decades, posting their “longest string of monthly gains” and “outpacing gains in corporate bonds and U.S. government debt.”

asset classes
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The Journal writes:

Investors are flocking to the $3.6 trillion municipal bond market at a time of low interest rates, uneven global growth and concern that the nearly uninterrupted rise in many stocks and bonds since the financial crisis will come to an end. The debt is especially attractive because interest payments typically don’t generate federal taxes and, in some cases, aren’t subject to state taxes.

Multiple Asset Classes and the Magic of Mean Reversion

The graph below, taken from Roger Gibson’s own research, is the result of tracking nearly 40 years’ worth of market data. He looked specifically at four asset classes: U.S. stocks, foreign stocks, commodities and real estate securities. He then examined what happened if you steadily blended these equities.

asset classes
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You can see the historical risks and rewards of 15 different types of equity portfolios Gibson assembled—four composed of a single asset (the blue squares), six composed of two assets (the red triangles), four of three assets (the green diamonds) and one containing all four assets (the yellow circle).

With  one exception—real estate securities (C)—the portfolios that contained only one type of asset class tended to offer the least amount of annualized returns and pose the greatest volatility. When you blended the equities—two at a time, three at a time and then all four—both the returns and standard deviations improved. The yellow circle (ABCD), which makes use of all four asset classes, ranked as one of the least volatile, most rewarding portfolios.

What’s amazing is that the most volatile asset class, commodities (D), helped constitute the very top-performing portfolios: ACD, BCD, CD and ABCD. Again, this demonstrates Gibson’s point that “portfolio volatility is less than the weighted average of the volatility levels of its components.”

Or put another way:

For investors concerned primarily with maximizing portfolio returns, we see that multiple asset-class strategies have dominated single-asset-class strategies.

Just as you must have discipline to pace yourself and complete a marathon, it takes discipline to regulate and manage your emotions while rebalancing your portfolio. It only makes sense to pivot into asset classes that

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