When 2016 started, investors were asking, “What’s safe?” Not so at the start of this year.
The stock market rallied at year end after the November election as prospects for economic growth improved. The question today is then, “Where will the growth be?”
The answer is: only in stocks.
Stocks and bonds are the major classes of financial assets. However, some financial advisers place so-called alternative asset classes, such as real estate and commodities, in their recommended investment portfolios.
A simple stock and bond portfolio works better.
Over the last century, a portfolio with 50 percent U.S. bonds and 50 percent U.S. stocks had the best risk-reward tradeoff. 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.
Some investors are turning to real estate, since returns have picked up substantially since the housing crisis eight years ago. As of October 2016, the S&P CoreLogic Case-Shiller U.S. National Home Price Index was 5.6 percent higher than the year prior.
Local commercial real estate is also stronger. Boise’s Thornton Oliver Keller reported in December that vacancy rates over the last quarter were relatively steady. Low vacancy rates keep lease rates and cash flow high.
Even with improved returns, real estate carries significant risks for the individual investors. Mutual funds or real estate investment trusts provide diversification, but the costs of running these funds is high. Real estate transaction costs in the fund are much higher than for stocks and bonds.
A further issue is that real estate and the other alternative investment classes 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. In contrast, the returns on bonds and stocks are generally uncorrelated.
Even with the selloff in bonds since the November election, stocks are priced well compared with bonds. The earnings yield on the S&P 500 stock index is currently just under 4 percent, compared with a current yield of only 2.4 percent on 10-year US government bonds.
One good New Year’s resolution is to keep things simple. For most investors, that means just stocks and bonds.