by Russ Allen, Online Trading Academy Instructor
It is hard to tell where to invest in unsettled markets. There have rarely been times as unsettled as these, as a perusal of any day’s news will show. Markets soar and sink with every headline and tweet. Trying to punt by keeping all our money in cash seems to be a self-defeating option with the historically low interest rates we are experiencing.
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The nearest parallel to today’s economic environment is the late 1920s and early 1930s, when a rolling thunder of competitive currency devaluations and retaliatory tariffs led to the collapse of the international trade system and eventually much worse. Could it happen again? There is no way to know for sure.
Which Assets Will Hold Value in Volatile Markets?
What we do know is that some assets will retain some value as long as there is a civilization; and that their prices will fluctuate differently. Unfortunately, we can’t know in advance which ones will be the best at holding or increasing their values. However, a long history does suggest that in combination, the big four asset classes, as I’ve just decided to call them – cash, stocks, bonds, and gold – have held up remarkably well as a group, even when some of them have had big drops.
Holding a portfolio with a combination of cash, stocks, bonds and gold, when properly re-balanced periodically, has proven to be a good strategy for maintaining value through all kinds of economic situations.
Pros and Cons of Holding Cash
Pros: There is no price risk with cash and it offers the ultimate amount of liquidity and returns rise in times of rising interest rates, with little lag.
Cons: Cash typically offers low returns, especially in times of low interest rates. Often, after taxes, returns are actually negative.
Pros and Cons of Holding Stocks
Pros: Stocks typically offer the highest average return of all asset classes. Though stocks may suffer losses, corporate influence and the way the system is designed makes likely that drops in the stock market will only be temporary.
Cons: Sometimes temporary drop in the stock market is a long time, on the time scale of an individual investor and there can be extreme volatility in the short run which could wreak havoc on returns as well.
Pros and Cons of Holding Long-term U.S. Government Bonds
Pros: U.S. Government Bonds have little to no risk of default, values often are counter-cyclical with stocks and they can generate some cash flow.
Cons: U.S. Government Bonds usually only offer only modest returns compared to stocks and are subject to some volatility.
Pros and Cons of Holding Gold
Pros: Historically (over 2,000+ years of history), gold has preserved its purchasing power through good times and bad, and the rise and fall of currencies and governments. The price movements in the gold market have no persistent correlation to those of stocks or bonds. Gold is convenient and liquid if held in the form of ETF shares.
Cons: Gold has no cash flow and there are costs associated with storage and security if it is held physically.
A Simple Portfolio for Volatile Markets
A simple and low-intensity way to invest is initially to combine the Big Four in equal parts, by selecting an exchange-traded fund (or mutual fund if in an employer’s 401(k) representing each one; and then leave them alone for a year. At the end of the year, add up the total values of the four funds and divide by four. Re-balance each fund to that value by selling or buying shares as necessary. Go away for another year. Rinse and repeat.
This strategy has the virtues of simplicity, ease of use, and low transaction costs. If we believe in it and resist the temptation to fuss over it, we could completely avoid the day-to-day anxiety of market gyrations.
So, can we believe in it?
Over the last forty years, for which we have good detailed historical data, a portfolio like this had these characteristics. The individual assets’ own values are also shown for comparison.
For the period, the combined portfolio never had more than one losing year in a row. The one big losing year was 1981, when it lost 5.61%. That year was bracketed by years in which it gained 13% and 23%; and in no other year did the combined portfolio ever drop by more than 2.75%.
This lack of drama for the portfolio as a whole is in stark contrast to the worst-year and multiyear-drawdown figures for the individual components, which individually had worst-year drops of 13% to 37%. This is the power of diversification.
There are more exciting, and potentially more profitable, approaches to investing. But for ease, simplicity and a low stress level, this one could be hard to beat.
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