Smart asset allocation may be the only protection against chaotic times

Feb. 24 (Bloomberg) -- Jeremy Siegel, a professor of finance at the University of Pennsylvania's Wharton School, and John Brady, senior vice president at MF Global Inc., talk about the impact of oil prices on U.S. stocks and the outlook for equities and Federal Reserve policy. They talk with Matt Miller, Carol Massar, Julie Hyman and Adam Johnson on Bloomberg Television's "Street Smart." (Source: Bloomberg)
By James K. Glassman
Special to The Washington Post
Saturday, March 5, 2011; 7:26 PM

Once again, an utterly unpredictable event has jolted financial markets and frightened investors. This one occurred in Libya, a sandy nation of six million ruled by a very strange man for more than 40 years. Rebellion swiftly drove global oil prices sharply up and the Dow Jones industrial average down. Better get used to it. We live in an era of shocks to the system, of improbable occurrences that can wreak havoc with your psyche and your 401(k) plan.

Slowly and reluctantly, after three decades writing about finance, I have come to the conclusion that because the world has changed, investment strategy must change with it. The old rulebook, which served us so well for nearly a century, needs revising. The rush of recent bolts from the blue - the attacks of 9/11, the BP oil blowout, the "flash crash" that sent the Dow tumbling 1,000 points in minutes and the unprecedented collapse of U.S. home values - is no fluke. These nasty surprises are a consequence of a world in which technology can have cataclysmic effects - first, by permitting the few to have a huge impact on the lives of millions and, second, by connecting, widely and instantaneously, markets that are often ruled by speculation.

My own chaos theory for investors can be summed up this way: Protect yourself by building a portfolio that reduces your downside risk. You can't do that with an all-stock portfolio, or anything close to it.

Readers of my column in The Washington Post will recognize that this is a change of heart. They remember me as the ultimate proponent of U.S. stocks. My credo was: Buy diversified equities and hold them forever. If you judge from history, you could be confident that, while stocks may decline in the short term, they recover - and then some - in the long term.

My advice after a terrible year like 2008, when the Standard & Poor's 500-stock index lost 37 percent, would have been to suck it up. Don't whine. Don't fret. Just wait until stocks recover. And certainly, stocks have come back. But I now recognize that for most investors, perseverance is hard; the anxiety is just too great. They need a smoother ride, without the roller-coaster dips.

I also believe it's possible that stocks won't come back, as they have not, for instance, in Japan, or on our own Nasdaq. For the broad sweep of U.S. stocks, the future will not necessarily be like the past - first, because the world has become more fraught with danger and volatility, and second, because the United States is in a condition of relative economic decline.

The experts at the Congressional Budget Office, reflecting the conventional wisdom among economists, see sustainable GDP growth (after a brief recovery blip this year and maybe next) at around 2 percent, compared to about 3.5 percent for the second half of the 20th century. Since corporate profits determine stock prices and since those profits are linked to overall growth, we can expect a slowdown in the historic rate of U.S. stock returns.

Instead of the historic average of 10 percent annually, U.S. stocks might return only 8 percent. Or less. Of course, it's possible that policy changes - like increasing immigration of skilled workers or boosting K-12 education achievement or severely cutting the corporate income tax - will increase growth. My point is simply that the likely prospects for investors aren't the same as they were in 1990 because the world isn't the same. Most sensible investment advisers - including me - have extrapolated the long-term financial past into the long-term financial future. Today, I think that is a mistake.

Look for safety

What I propose instead is a safety net - a hedge, a backstop, an insurance policy, a way of breaking any potential fall. For most investors, the easiest hedging strategy comes through asset allocation - that is, the way you divide the financial vehicles you own (primarily stocks and bonds). Asset allocation is the most powerful weapon in an investor's arsenal. Allocation, rather than, say, the choice of individual stocks, is the key determinant of performance.

Consider a retirement portfolio of $100,000. In the past, for someone age 40 with a time horizon of about 25 years until retirement, I would have recommended an investment of $90,000 in stocks (either shares of individual U.S. companies or mutual funds) and $10,000 in bonds (typically, in debt issued by the U.S. Treasury). Now, instead of a 90-10 split, the safety-net approach requires 50-50.

Morningstar, the research firm, maintains an excellent database, developed by the economist Roger Ibbotson and dating to 1926. Over this period, a diversified basket of U.S. large-cap stocks returned about 10 percent and intermediate-term Treasury bonds returned about 5 percent. So, if the future is like the past, we can expect a 90-10 portfolio to return about 9.5 percent, or $9,500 ($9,000 from the stock part and $500 from the bond part). A 50-50 portfolio, by contrast, would return $7,500 ($5,000 from stocks and $2,500 from bonds).

So the cost of switching to 50-50 - again, if the future is like the past - is about 2 percentage points a year. What do you get for such an insurance premium?

CONTINUED     1        >

© 2011 The Washington Post Company