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Smart asset allocation may be the only protection against chaotic times
The Morningstar data show that a 50-50 portfolio reduces volatility dramatically. Since 1926, the biggest one-year loss for a 90-10 portfolio was 40 percent; for a 50-50 portfolio, 25 percent. The worst five-year loss for the 90-10 portfolio was an annual average loss of 10 percent; for a 50-50 portfolio, 3 percent. Over five years, the value of a $100,000 portfolio split 90-10 fell to only $59,000, while the 50-50 portfolio declined to $86,000.
Or consider an all-stock portfolio, which I would have advised in the past for people in their 20s and 30s. In the disastrous year 2008, such a portfolio lost 37 percent while a 50-50 portfolio lost 10 percent. What about in a good year for stocks? Try 1997, when the S&P 500 stocks returned 33 percent. A 50-50 portfolio was up 25 percent. Still, awfully good.
If the future is worse for U.S. stocks than the past - as I expect it will be - then the insurance policy will be even more attractive.
Asset allocation is not the only way to hedge. You can own a "bear" mutual fund like ProFunds Short S&P 500, whose value moves inversely to the market - if stocks fall 20 percent, the fund rises about 20 percent (and vice versa). You can sell covered calls on stocks you own, in effect creating a "collar" around a stock's price, reducing both the upside and the downside. You can own mutual funds like WisdomTree Dreyfus Emerging Currency, which hold portfolios of short-term debt denominated in foreign currencies that provide a hedge against a decline in the dollar.
Basics of chaos theory
But it is conventional stocks, bonds and mutual funds that are the foundation of chaos theory. Here are some characteristics of each asset class in the strategy I propose:
Stocks: A large chunk of the stock portion of your portfolio - between one-fifth and two-fifths - should be composed of the shares of companies based in developing (or, as I prefer to call them, aspiring) markets, such as India, China and Brazil. The reason is simple: These economies are expected to grow at 6 to 8 percent a year - or three to four times the rate of U.S. growth.
When Morningstar ranked geographical stock-fund categories for five-year performance through 2010, China region funds were far and away the best with average returns of 19 percent annually, followed by Latin American funds at 16 percent and Pacific/Asia (minus Japan) at 12 percent. After such spectacular performance, you might expect aspiring markets to take a breather - and they might, for a time. No stock, or sector, goes straight up, and these are especially volatile stocks. But over the longer term, ignoring these markets is foolish.
Also, investing in them is a lot easier than it was a decade ago. You can choose American Depositary Receipts or foreign stocks directly traded on U.S. exchanges. You can opt for portfolios such as mutual funds, closed-ends or exchange-traded funds (ETFs).
Particularly attractive are businesses that focus on domestic aspiring markets rather than those that depend on slower-growing export markets, like the United States and Europe for their sales. Good examples are China Mobile, the world's largest telecom company with more than 500 million customers and room to grow; Banco Bradesco, which caters to the financial needs of low- and middle-income Brazilians; and Tata Motors, the largest truck and auto manufacturer in India with revenues that have risen from $3 billion to $30 billion in eight years. All three trade on the New York Stock Exchange.
An excellent way to buy domestic Chinese businesses is through Global X China Consumer fund, a new ETF with holdings in such stocks as Home Inns & Hotel Management, with 600 hotels scattered around China, and New Oriental Education & Technology, China's largest provider of private education services, including test preparation and online learning. A more-seasoned mutual fund, Matthews China, has a domestic focus and has quintupled in value in 10 years. The drawback is a high expense ratio of 1.2 percent.
Aspiring-markets stocks are only one of four types of equities I advise owning. The others include one high-risk category, micro-cap stocks, the smallest of the small and two steadier categories: consistent dividend payers like Procter & Gamble and unloved value stocks like Microsoft, which carries a price-to-earnings ratio, based on expected earnings this year, of just 10.
Bonds: The bond part of your portfolio is strictly for income. It's the safe part of the strategy. Do not try to make a profit betting on the possible rise of a bond's price. Instead, collect the interest, and hold the debt to maturity.
A smart bond strategy is called "laddering" - owning bonds with successive maturity dates. For example, you can might own 10 separate bonds with maturities a year apart: 2012, 2013, all the way to 2021. When the 2012 bond matures, you take the cash and buy a new bond maturing in 2022. If rates go up, your 2022 bond will pay a new, higher rate, thus protecting you against interest-rate or inflation risk.
The objective is to collect interest of around 5 percent annually from your bonds. Currently, the average high-quality 10-year corporate bond is in precisely this range. For example, a GE Capital bond maturing in January 2021 and carrying an AA+ rating from S&P was recently yielding 4.7 percent, while a Morgan Stanley bond with the same maturity date and an A rating was yielding 5.3 percent.
U.S. Treasury issues are yielding a good deal less. You have to accept maturities as long as 16 years and more to get interest in the 4 percent range. My strong suspicion, however, is that with the loose-money policy the Federal Reserve has adopted, inflation will eventually rise and, with it, interest rates. As a result, you should consider TIPS, or Treasury Inflation-Protected Securities, which raise their returns with increases in the Consumer Price Index. A TIPS bond maturing in 10 years carries a base yield of 1 percent. If inflation jumps to 4 percent, the effective yield rises to 5 percent annually.
But, again, it's not the specific securities that matter as much as the allocations. In a time of chaos and decline, you need a portfolio that offers a safety net to catch you if you fall.
And what if I am wrong? What if the storm clouds dissipate and stocks revert to their historic mean? If the stock market is strong, then it's likely the economy will be, too. Your pay will be rising, your own business thriving and your house increasing in value. Yes, you have given up a few upside points by taking out an investment insurance policy, but you will be too delighted to notice.
Glassman, a former undersecretary of state, wrote the Investing column for The Washington Post from 1993 to 2004. He is a columnist for Kiplinger's Personal Finance and executive director of the George W. Bush Institute in Dallas. He is the author of "Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence," from which parts of this article were derived.