Yes, stocks are expensive now. Yes, bonds have a lousy yield. Here’s what you should do
.jpg "The “Fearless Girl” bronze sculpture looks towards the New York Stock Exchange. With stocks at record highs, the question looms: Should you look for investment returns elsewhere?")
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After a quick sell-off when the COVID-19 shutdowns began last spring, the stock market has rallied to new record highs. This rapid bounce back has many investors asking whether or not they should get back in, or look for returns elsewhere.
Some financial advisers are recommending “alternative” investments, such as real estate and commodities. Gold investing is back in style. It is often argued that diversifying into these other asset classes reduces risk.
The evidence suggests otherwise. A portfolio of just stocks and bonds works better.
Over the last century, a portfolio with 50% U.S. bonds and 50% U.S. stocks had the best risk-reward trade off. That is, the 50-50 portfolio provided the highest possible return with the least amount of risk as measured by the portfolio’s standard deviation. Even during the 2007-09 financial crisis, a 50-50 portfolio performed well.
Real estate and the other alternative investments don’t provide strong diversification for your stock portfolio. Economic theory predicts and historical research supports a strong positive correlation between stock prices and these other assets. That is, stocks should do well themselves when the price of real estate and commodities are rising. In contrast, the returns on bonds and stocks are generally uncorrelated.
Even though potential returns real estate or commodities may be high, such investments have significant risks for the individual investors. The transaction costs in a commodity mutual fund or a real estate investment trust are much higher than for stocks and bonds. Meanwhile, the costs of stock mutual funds continues to decline.
But even after considering these issues, one may still not think it is a good to time to invest. Interest rates are at historic lows, and the run-up in stock prices makes them too costly.
Yes, stocks may not be the deal they once were, but they are still priced well compared with bonds. The earnings yield on the S&P 500 stock index is currently 3.5%, compared with a current yield of less than 1% on 10-year U.S. government bonds. It therefore remains a good time to invest in stocks if you’re willing to hold on for the long-run.
As is true for many things, keep it simple. For most investors, that means just stocks and bonds.
Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. prcrabb@nnu.edu