A well-built portfolio should have 3 legs to stand on, rather than just the traditional two. The improvement in stability and structure from adding a third “pillar” to a portfolio is obvious to all. Portfolio manager Rob Arnott, points out that the first two pillars of a portfolio are core stocks and core bonds and the third pillar consists of “diversifiers”, whose role is to provide positive returns with low correlation to traditional stocks and bonds. While all three pillars can produce positive (or unfortunately, negative) returns in any market environment, the first two tend to produce their best results in times marked by relatively low levels of inflation and some economic growth. The third pillar of diversifiers can seize opportunities in a variety of ways and may offer good results in times of higher inflation, economic turmoil, etc.
In times of inflation, traditional bonds are likely to have negative real returns and stocks are likely to have post rather anemic returns. Several diversifiers from your third pillar should fare quite well in such times. Commodities, TIPs bonds (those that offer a return pegged to inflation), and floating rate bonds would all be expected to do well at counteracting inflation.
While many forecasters (or predictors) choose to move you around from one area to another based on their beliefs about inflation, economic growth, etc., we think that can be a recipe for disaster. Monkeys throwing darts seem to be right about as often as the best and brightest forecasters. These forecasters typically rely on two pillars or possibly only one pillar in order to achieve results. You can picture how sturdy your economic future is when you rely on a one pillar portfolio. One mistake at any time has crushing results. We think building a sturdy vessel is your best first defense. There is a good case for inflation moving forward and a good case for deflation also. Why not build a portfolio which has the potential to survive either case?
We know it is comforting to have an “expert” tell you what the future holds, but we neither feel up to that task nor do we believe anyone else is up to it. Those who are the most certain (which feels like a comfort to you as a prospective investor) are those who may be most likely to be wrong. The road to disaster is filled with yesterday’s experts. Only when knowledge is combined with humility can you manage risk successfully.
We believe that we continue to journey down a risky trail. The tried and true path to success is likely to be the same as it always is-buy low and sell high. While US stocks have behaved as though we were in a booming economy with the wind at our back, other assets types have struggled and appear to be underpriced at this point. Examples would be emerging market debt and equities, which seem to offer attractive future returns when compared to US stocks and treasuries. We know it is enticing to chase returns and sell your emerging market stocks in order to add to your US stocks since they are doing so well. We expect our third pillar diversifiers to do exactly the opposite. We expect them to buy what should offer the best returns going forward, by stocking up on “sale items” like emerging market stocks at this point. The idea is pretty simple. The three pillars are designed to work together through an entire market cycle to produce excellent risk adjusted returns. The idea is not that it will always work well in shorter periods, but that it works well in helping you achieve long term results. Remember, Einstein’s eighth wonder of the world is compound interest. Big gains today feel great, but big losses derail the long term compounding of money in a way that cannot be overcome.
By Ted Schwartz, CFP©