Noted economist John Maynard Keynes once famously remarked that 'trees don't grow to the sky' -- a phrase all investors should keep in mind when building a strong portfolio. This basic truism seems to get ignored when investors are caught up in the euphoria of long bull markets in stocks.
Many investors make this same mistake we're all prone to: Seeing a current trend and extrapolating it indefinitely into the future.
David Kahneman, the psychologist who was awarded a Nobel Prize for economics in 2002 for his work in identifying irrational decision making, has spoken about the tendency for human beings to extrapolate current trends. He suggested that this tendency is what helped create the U.S. housing bubble, saying ,'It takes very little time for people to perceive a trend and to assume that it goes forever.'
It's this kind of thinking that leads investors to ignore asset allocation guidelines when building a strong portfolio and move their holdings to 100% equities (or more simply, stocks). They extrapolate the bull market trend infinitely into the future, expecting the stock 'trees' to grow forever.
Asset allocation teaches (and a strong portfolio requires) investors not put all their eggs into one basket, however. Investments should be allocated across many asset categories, including U.S. stocks, bonds, cash, foreign stocks, and alternative asset classes such as real estate and commodities.
There are several reasons investor should divide their portfolio across asset classes. First of all, some of these asset classes move in opposite directions, which can smooth out the return on an investor's overall portfolio. For example, if the stock portion of a portfolio is falling, the decline may be offset by the gains recorded by the bond and cash portion of the portfolio.
How a 100% Stock Portfolio Compares to Other Asset Classes
Conventional wisdom has been that the only sure way to achieve superior long-term returns and build a strong portfolio is to over-allocate funds to the stock market. But that's not the case. One study conducted by Rob Arnott of Research Associates showed that in the 41-year period from February 28, 1968 to February 28, 2009, the returns on the S&P 500 actually trailed the returns from the 20-year U.S. Treasury bond (on a rolling basis) by two hundredths of a percentage point. Bonds actually outperformed stocks over that period!
Another study from the Yale School of Management's Center for International Finance looked at the returns of stocks versus commodities futures over the last half century. It found that in the period from 1959 to 2004 commodities futures produced comparable annual returns to stocks. It also found that during the same period, commodities futures actually showed less volatility.
Diversification Among U.S. Assets is Not Enough
Long-term investors should alsoin mind that a well-built portfolio will also include assets in currencies other than the U.S. dollar. Owning foreign securities and/or currencies will help protect investors' portfolios against any decline in the value of the U.S. dollar.
Think this isn't a major concern? Consider that one U.S. dollar in 2009 only bought about the same amount of goods and services that $0.20 bought in 1971.
Another important concept is that all assets classes go through their good and bad periods, where they are either way up or way down. A sound portfolio should never chase performance. When stocks are sinking and bonds are soaring, don't dump stocks and go to a 100% bond allocation. A 100% allocation in any asset class is a mistake if you are looking for long-term returns.
Very few investors can always figure out which asset class is going to be up and which asset class is going to be down during a set period of time. Therefore, investors should spread out their investments over different classes. Having eggs in several different baskets is the best way to see long-term growth in the value of their investments.