After two bear markets in the first 10 years of the 21st Century, investors now seem to understand that stock market losses can be deep. Bonds offer relative safety, but low yields may not offer enough income for many investors who are worried about stock market volatility. all weather investing looks beyond the typical stock/bond/cash portfolio in an effort to benefit from market gains, while seeking some protection of capital on the downside.
When stock markets dipped in the 1990s, analysts called it a correction and individual investors viewed it as a buying opportunity. From 1982 through 1999, buy-and-hold had been the king of investment strategies, as the S&P 500 delivered an annualized return of over 18%. Stock investors were reminded of the meaning of risk in the next 10 years, as those two bear markets led to an annualized return of -0.99% a year through the end of 2009. Realizing that financial storms can disrupt retirement plans, some investors considered the safety of bonds to provide steady income, unfortunately triple-A corporate bond yields were falling over that same time and yielding only 5.31% on average at the end of 2009. Safe Treasury bonds hovered near 3%.
In this environment, some investors became familiar with the idea of all weather investment strategies, which are designed to capture steady gains and limit volatility. The unpredictability of returns is one definition of volatility. When stocks fell more than 50% after the top in 2000, many 401k investors were forced to rethink their retirement plans. The recovery that began in 2002 had some investors back to where they started in five years, but the declines of 2008 and 2009 presented yet another setback, and many portfolios ended the decade at about the same level as where they stated.
Volatility can be decreased by diversification. One of the simplest all weather techniques is to create a balanced portfolio with 60% invested in a broad stock market index fund and 40% invested in bonds. During the lost decade that ended in 2009, one study found that this approach would have yielded an annualized average return of 2.6% a year.
This shows that adding asset classes can help to reduce risk. Unfortunately, many investors have failed to consider options besides stocks and bonds. Even the most adventurous may include a fixed allocation to gold and consider themselves well-diversified. Exchange-traded funds (ETFs) offer individual investors access to markets all over the world, and some of these funds offer access to asset classes that once required large investments. Perhaps most importantly, global asset class diversification could have helped deliver profits in the first decade of the 21st Century.
SEE: Why ETFs Are A-OK
Broadly speaking, there are at least 12 different asset classes - U.S. large-cap, mid-cap and small-cap stocks; foreign stocks in developed and emerging markets; corporate, government, foreign and inflation protected bonds; real estate; money market and commodities. ETFs can be used to access each of these classes.
Ask the Experts
Dr. Craig Israelsen, a professor at Brigham Young University, has shown that buying those 12 different classes can help investors achieve average returns that almost match stock market returns while having about the same level of volatility as an all-bond portfolio.
He maintains a part of the portfolio in cash, and found a model portfolio would have doubled in value using ETFs. This result relied on monthly rebalancing, restoring each position to their original allocation percentages at the end of each period. He also shows that less frequent rebalancing, done even as seldom as annually, can beat a simple buy-and-hold investment in stocks.
Nobel Prize-winning economist Burton Malkiel studied a diversified mutual strategy and found that an investor could have almost doubled his money from 2000 to the end of 2009 by using index funds. He looked at broadly based, low cost index mutual funds that focused on U.S. bonds, U.S. stocks, developed foreign markets, stocks in emerging markets and real estate securities. ETFs can offer lower costs to access each of these areas. That is a significant advantage to the long-term all weather investor. An ETF expense ratio may be half as much as the expense ratio of a mutual fund and the difference in expense ratios increases annual returns.
The work of Mebane Faber demonstrates that moderately active management can help investors avoid the worst of bear markets. Faber looked at five asset classes - U.S. stocks, foreign stocks, real estate, commodities and the U.S. 10-year Treasury bonds. He used a simple buy rule, holding the asset only when it was above its 10-month moving average.
The moving average is designed to look beyond the short-term trends within price data and help investors spot the longer-term trend. Faber's study assumes that you only own the asset class when it is on a buy signal. When prices fall below the 10-month average, you move to cash for that portion of the portfolio. The results are impressive, an average annual return of 11.27% from 1973 through the devastating bear market of 2008.
To implement any of these strategies, a wide range of ETFs can be used. Some examples include:
- U.S. large-cap stocks: SPDR S&P 500 (NYSE:SPY)
- U.S. mid-cap stocks: Vanguard Mid-Cap ETF (NYSE:VO)
- U.S. small-cap stocks: Vanguard Small Cap ETF (NYSE:VB)
- Foreign stocks in developed markets: Vanguard Europe Pacific ETF (NYSE:VEA)
- Foreign stocks in emerging markets: Vanguard Emerging Markets Stock ETF (NYSE:VWO)
- Corporate bonds: Vanguard Total Bond Market ETF (NYSE:BND)
- Government bonds: Vanguard Intermediate-Term Government Bond Index Fund (NYSE:VGIT)
- Foreign bonds: SPDR Barclays Capital Intl Treasury Bond (NYSE:BWX)
- High yield bonds: iShares iBoxx High Yield Corporate Bond (NYSE:HYG)
- Real estate: Vanguard REIT Index ETF (NYSE:VNQ)
- Commodities: PowerShares DB Commodity Index Tracking (NYSE:DBC)
The Bottom Line
There are many other ETFs that can be used. Rebalancing can be done as little as once a year, as shown by Israelsen, or once a month, as shown as by Faber. Either way, all weather investing can be done in a relatively low maintenance portfolio.