Selecting Your Assets

hands-laptopThe table below depicts my recommendations about which asset classes to include in your portfolio. This is not a clear-cut decision. There are varying opinions among investment professionals. Read on for my research and conclusions.

Which Assets to Buy?

The average investor typically uses only the basic building blocks of stocks, bonds and cash. They are not aware of sub-asset classes or other more esoteric asset classes such as hedge funds, private equity and commodities. You can do just fine with only the basic asset classes. However, adding other asset classes can yield more efficient portfolios, with higher returns per unit of risk. Later I will show you some sample portfolios, ranging from simple to more advanced.

The average investor typically uses only the basic building blocks of stocks, bonds and cash.

Residential Real Estate
Hedge Funds
Private Equity
Commodity Equities
Gold Mining Stocks
Buyer Beware!


  • Over the long run, stocks have been the most reliable and consistent performer of all asset classes, with US stocks returning 10.7%/yr. from 1926-2000.
  • However, there can be long periods when stocks don’t do very well, e.g. in the U.S. from 2000-2010 (0.40%/yr.) and 1928-1948 (2.5%/yr.). As mentioned earlier, many financial experts believe U.S. returns going forward will be significantly less than in the past, i.e. 4-6%/yr. nominally.
  • Depending on market conditions, returns typically exceed the inflation rate and therefore serve as an inflation hedge.
  • Given the changes in the global economy, current valuations, enormous U.S. and World debt, increasing government regulation and size, aging population, more mature economy and global competition, there is a strong case to be made that U.S. stocks will not perform as well in the future as they have in the past.
  • I believe a significant portion of your portfolio should be allocated to equities, with a mix of:
    • Small, mid-cap and large cap
    • U.S. and Foreign (including Emerging markets and Developed markets)
    • REITs
    • Natural resources (e.g. gold stocks and commodity producers)

US Equities vs. the Rest of the World

The U.S. has about 45% of the world’s total equity which might suggest you hold that percentage of your stocks in U.S. stocks. However most investment advisors suggest 70-80% in the U.S. and the rest in foreign equities. However the U.S. has only 28% of the world’s GDP and its valuation (near record high Shiller P/E) and long term growth prospects are arguably lower than many other countries, especially faster growing emerging markets. Also, the U.S. carries currency risk given huge long term debts, the political landscape, and the Fed’s large balance sheet and easy money policies. In my view this suggests a lower U.S. allocation percentage. As a result I prefer to hold a lower weighting of US stocks vs. what conventional advisors recommend.

The Equity Style Box

The equity style box uses two dimensions to categorize equities – size (based on market capitalization) and orientation (growth vs. value).  Over the long run, small cap value stocks have outperformed mid and large cap, and value stocks in general have outperformed growth stocks. However, there is no guarantee this will persist.

Note that the style box does not address another key equity attribute – location (U.S. or Foreign). The chart below gives you an idea of how the third dimension (location or country) has affected performance when combined with the large- and small-cap dimensions. Depending on the time period, certain styles outperform others. For example, in three of the four decades International Small Cap stocks were the best performer, except for the 1990’s.  International stock performance is influenced by currency movements. If the dollar is declining relative to foreign currencies, foreign stocks perform better in dollar terms and vice versa if the dollar is strong. Large cap U.S. stocks were going gangbusters in the 1990’s but if you over-invested in them going into the first decade of the 21st century and held on you would have been in the worst sector for 10 years.

Sectors move in and out of favor over time so it is hard to pick the best ones going forward. Again, this is why it’s wise to diversify across asset classes and sub-asset classes vs. making major bets on sectors.

Asset Class Performance by Decade

Emerging Market Equities

Emerging Market stocks have higher expected returns than similar non-emerging market stocks (albeit with higher risk). As you can see in the asset correlation table here, Emerging Market stocks tend to have relatively low correlations with other asset classes, so including them in a portfolio should improve the portfolio’s risk/return characteristics.

Emerging-market economies comprise about 13% of world equity, yet their share of GDP is 30%* and they are growing faster than developed markets. I believe that this, combined with their current more attractive valuation vs. U.S. stocks makes them a favorable investment. As of late February, 2015, the P/E ratio of the FTSE Emerging Markets index was 14.8 vs. the S&P 500 Index at 19.0.

*Source: Columbia Business School – Finance and Economics; National Bureau of Economic Research (NBER)

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) represent an investment in commercial real estate equities. Examples include malls, office buildings, medical office buildings and residential apartments. There are also mortgage REITs but the focus here is on equity REITs which I believe are the more attractive asset.

Some professional investors categorize REITs as an “alternative investment,” since they represent an ownership in commercial real-estate property, which has its own unique characteristics. However, they are available as individual equities, equity mutual funds and ETFs.

Over the long run, REITs have several attractive features:

  • A highly liquid form of owning professionally managed real estate.
  • Higher long-term returns compared to general equities – 13.9%/yr. vs. 12.9%/yr. (1978-2007).*
  • Attractive dividend yields.
  • Relatively low correlation with general equities: ranging from about 0.30-0.50 over the long term. However these correlations have varied widely, being as high as 0.88 in the late 1980’s and around 0.70 in recent years.
  • In some bear markets, REITs have gone up while the overall market has gone down:
    • 1981: REITs were up 18% vs. S&P 500 down 5%.
    • 2000-2002: REITs up 15%/yr. vs. S&P 500 down 15%/yr.
    • However in the 2007-2008 bear market, REITs were down 16% and 37% respectively vs. the S&P 500 up 5% and down 37%.

REITs have performed well in recent years, with attractive total returns.

REIT Performance

However, as their yields have made them very popular, their valuations have increased substantially in recent years, reducing their appeal somewhat.

Foreign REITs offer additional diversification benefits (dollar hedging and lower correlations) and slightly more attractive valuations, in my opinion.

Some cite inflation protection benefits, but data do not support this.

*Source: Alternative Assets, Swedroe, 2008, pp 5-6

Residential Real Estate

Since 1970, on average, U.S. real estate prices have essentially tracked inflation. The housing crash after the bubble corrected the price back to its long term trend line which is slightly greater than a zero real rate of return.


Housing long term real returns are between 0.1% and 1.3%. If you own a home, your returns may not be anywhere near the same as those of the overall housing market due to local factors and lack of diversification. Some may be able to buy and sell real estate at a profit, but in my opinion that should be considered a profession, or perhaps just speculation.

A home should be viewed first and foremost as a consumption purchase, not an investment.

Housing Long Term Real Returns

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, IPD, WGC and studies cited in text

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, IPD, WGC and studies cited in text

According to a Credit Suisse Report, “Global Investment Returns, 2012,” housing provides real returns that are near the rate of inflation: “We conclude with a record of housing prices since 1900 for six countries, drawing on several studies of which Monnery (2011) is the most recent. Housing has provided a long-term capital appreciation that is similar in magnitude to gold. The best-performing house-price indexes are Australia (2.03% per year) and the United Kingdom (1.33%). The United States (0.09%) is the worst. Norway (0.93%), the Netherlands (0.95%), and France (1.18%) fall in the middle.”

This is depicted in the graph below.

Credit Suisse goes on to say: “House price indexes are notoriously difficult to interpret, but they do appear to have kept pace with inflation over the long term. Nevertheless, one must remember that a home is a consumption good, as well as an investment. Investors can never build a properly diversified portfolio of housing. The attributes of a home are a by-product of its intrinsic utility to those who dwell there.”

Larry Swedroe draws the same conclusion in his excellent book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” by Swedroe and Balaban.


Bond yields are historically low and carry great risk. Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. If a bond has a duration of 10, for each one point increase in interest rates, the principal value of the bond will decline by 10%. For example, at the time of this writing, the Vanguard Long Term Treasury Fund has a duration of 16.4 years and yields 2.25%. If the market yield on long term treasuries were to rise by two percentage points to 4.25% (roughly its historical average), then the market value of this mutual fund will drop by almost a third (2 x 16.4 = 32.8%).

  • Based on this and more detailed analysis of the long-term risk-return behavior, I currently recommend investment only in short-term, high quality bonds and TIPS (long and short term).
  • TIPS currently carry yields close to zero, which compared to the long run equilibrium yield of 2-3%, is not attractive. Short-term TIPS offer better near-term interest rate risk protection and may be considered in addition to traditional long-term TIPS. However, TIPS pricing implies 10 year average inflation of less than 2%, which is below long run historical levels and the 2% target of the Federal Reserve Board. This signals potentially good value. See this article for more.
  • Foreign bonds provide higher yields than U.S. bonds for a given unit of risk and provide a US dollar currency hedge (for local currency denominated bonds). I recommend holding them for portfolio diversification. However, there are good arguments for investing in a currency-hedged version of these bonds. Read this for more on that.
  • Over the long run, the numbers show that junk bonds do not provide returns that compensate for their risk. While investors have done well with them in recent years, I recommend avoiding them as a long-term investment holding. They behave more like equities than bonds.

Hedge Funds

Hedge funds differ from mutual funds in several ways:

  • They aren’t available to individuals unless they are accredited: have net worth of at least $1M or annual income of at least $200K for an individual.
  • Unlike the typical broadly diversified mutual fund, they generally have highly concentrated large positions in just a few securities.
  • They have broad latitude to make large bets (either “long” or “short”) on almost any type of asset, e.g. commodity futures, options, real estate, currencies, foreign debt, stocks, gold, etc.)
  • Management generally has a significant stake in the fund, limited regulatory oversight and reporting, strong financial incentives (and cost to the investor), typically 1-2% per year plus 20% of the profits.
  • They seek to outperform market indexes such as the S&P 500 by utilizing their skill, which might be based on finding market mispricing, superior forecasting, and/or securities selection.

On average, hedge funds don’t outperform the S&P 500 Index.

Hedge Fund Returns Vs. Common Indexes

The key reason they don’t outperform is cost. This is a familiar theme we covered earlier as it relates to mutual funds . From the table below you can see that an average hedge fund manager would need to generate excess returns (“alpha”) of more than 4% per year to beat the S&P 500 index over time. This is due to their high cost structure.

Required Hedge Fund Alpha to Beat the S&P 500

Hedge Fund Follies

Forbes magazine* reported:

If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good. From 1998-2010 the index returned only 2.1% annualized on a money-weighted basis, not 7.3%. During that time frame, he estimates that hedge fund managers earned $379 billion in fees, while “real investors” earned only $70 billion in profits. Thus, the operators earned 84% of the investment profits and investors only 16%.

*Forbes Magazine, citing The Hedge Fund Mirage (John Wiley & Sons), Lack, 2012

Key Takeaways – Hedge Funds

  • Hedge funds are much like actively managed mutual funds, with the returns dependent on manager skills and costs. And costs are usually exorbitant.
  • As such, it is very difficult to choose a skilled hedge fund manager who will outperform over an extended time period going forward.
  • Since hedge funds do not invest consistently in any particular asset class, they will have widely varying levels of risk-return profiles, so it’s not really fair to compare their performance to the S&P 500.
  • If you run your own portfolio with widely diversified asset classes (including alternative assets), your portfolio is already to some extent its own hedge fund, where you have chosen a given risk-return tradeoff with some non-correlated assets, without the costs and illiquidity of the hedge fund.
  • My opinion is that there is no role for hedge funds in an investor’s portfolio, given their historical returns, the unlikelihood of being able to select a superior manager and their high costs.

Private Equity

Private equity includes venture capital (seed funding), leveraged buyouts, and mezzanine (late stage, just before IPO) financing. It has these other distinguishing characteristics:

  • Accessible only by high net-worth investors.
  • Requires long holding period.
  • Most typically funds pre-IPO, start-up or early stage firms.

Here are key findings from Venture Economics:*

  • Private equity returned 13.8%/yr. for the 20 years ended June 30, 2005.
  • During the same period, the S&P 500 index and microcap stocks returned 11.2%/yr.
  • Small-cap value stocks returned 16.0%/yr.
  • Early stage venture capital (VC) returned 20.2%/yr., consistent with the higher risk.
  • On the whole, VC returns just matched the return of small-cap value stocks at 16%/yr., despite higher risks.
  • Later-stage VC underperformed small-cap value stocks at 13.8%/yr.

*Source: Swedroe & Kizer, “Alternative Investments,” 2008, p.125.

Source: Thomson Reuters/National Venture Capital Association

Source: Thomson Reuters/National Venture Capital Association

Key Takeaways – Private Equity

  • Venture capital does appear to have some potential as a reasonable investment alternative for advanced, high net-worth investors.
  • However, the average investor will not have access to venture capital, due to the requisite financial qualifications (typically seven-figure net worth or high income).
  • Success in picking a VC manager is similar to choosing a superior actively managed mutual fund. It requires due diligence and some fortune in being able to pick a manager that has and will in the future consistently perform well. This is a significant barrier for all investors, regardless of their qualifications to invest in VC.
  • Bottom line, I believe both the average and advanced investors do not need to invest in VC in order to achieve their goals.
  • Here is an excellent analysis on Private Equity as an investment.


Commodities consist of tangible or hard assets that are found in nature. A leading index of commodities is the Standard and Poors Goldman Sachs Commodity Index (S&P GSCI). The index comprises 24 commodities from all commodity sectors – energy products, industrial metals, agricultural products, livestock products and precious metals (e.g. gold, silver, platinum).

Most commodities cannot be purchased by individual investors due to the problems of storage and trading liquidity. For example, how do you buy, ship and store 100 barrels of crude oil? Buy a tanker to ship it and then store the barrels in your basement?

There are alternatives. Mutual funds that aim to track commodities prices typically use some form of futures contracts and deleverage them by placing most investor money in fixed income. Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) are available and usually track a commodity index.

Investors can also hire a commodity trading advisor and trade commodities directly or use managed futures pools. However this involves high management costs, leverage, and the risk of margin calls. Commodities tend to rise during inflationary times and are part of what constitutes inflation.

Many studies show that there are potential benefits of investing in commodities, including:

  • Inflation protection; a hedge against a declining dollar.
  • Protection in down equity markets.
  • Low correlation with stocks and bonds, leading to better portfolio diversification and higher portfolio risk adjusted returns.

According to Ibbotson, “Our historical analysis supports the claims that commodities have low correlations to traditional stocks and bonds, produce high returns, hedge against inflation, and provide diversification through superior returns when they are needed most…we found that including commodities in the opportunity set resulted in a superior historical efficient frontier…”

Problems with Commodity Investing

  • The most common way to buy commodities is via commodity futures. Without getting into all the details of this complex investment vehicle, the problem is that commodity futures behave differently than the underlying commodity, so it is very difficult for investors to earn the returns of the underlying asset by investing in the futures.
  • The return of an investment in futures contracts is often influenced by other factors, namely roll yield, which is the gain or loss incurred when a contract is replaced in order to avoid delivery of the commodity. As a result, the performance of a fund or ETF holding futures may not closely track the spot performance of its underlying commodities.
  • Investable commodities vehicles such as ETFs and ETNs have tax reporting ramifications that can complicate tax reporting. You can learn more here.
  • Commodity ETNs provide the best tracking mechanism of the underlying commodity, but they carry credit risk from the ETN issuer.
  • A study by Bernstein on Commodities concluded that “long only,” i.e. investing in a commodity index tracking mechanism is not a good strategy. Active management is required. And based on my analysis of active management on this site, this is a very iffy strategy.
  • There are many commodities mutual funds, ETFs and ETNs that aim to track the underlying return of a commodities index such as the GCSI, or even component parts, such as crude oil, but their track records so far aren’t very stellar:

Key Takeaways – Commodities

  • There is significant debate about the value of investing in commodities.
  • Commodities have not performed well in recent years, largely due to slower world economies and disinflation. However, inflation and commodity price appreciation may certainly return.
  • While the sampled investment funds above don’t do a bad a job of tracking their underlying commodity target index, there is risk that they will not be able to do so in the future.
  • Some experts argue that commodity futures are a derivative asset and have no intrinsic investment value.
  • The performance record of commodity futures has been pulled up by a huge weighting in energy futures, whose returns have been atypical of the broader set. In fact over 20 years ending in 2005, the average commodity underperformed both stocks and bonds.
  • Commodities sometimes failed to protect investors when diversification is needed most, e.g. in the 2008 market crash when major commodity indexed lost more than 30%.
  • At this time, I believe the evidence isn’t strong enough to invest in commodities. The problems and uncertainties outweigh the potential benefits, so I would avoid them.

However, I do believe that there are benefits from investing a portion of your portfolio in commodities equities and in a specific commodity – gold.

Here is additional research on commodities investing, with arguments both in favor and against. The Bernstein article is the most persuasive in my opinion and argues against them.

Vanguard: Investment case for commodities? Myths and reality
A Wealth of Commonsense: Do You Need Commodities in Your Portfolio?
The Wall Street Journal: Is Investing in Commodities a Good Idea?
The Daily Record: Worth Considering: Evaluating the investment case for commodities

Commodity Equities (also referred to as Commodity Producers)

Commodity equities consist of publicly traded stocks, mutual funds and ETFs that hold companies that are involved in commodity exploration and production. Examples include:

  • Oil exploration, production and services companies.
  • Agricultural products companies.
  • Precious metals mining companies.

In the case of a commodity producer such as a gold mining company, when the price of gold rises, the price of the stock will generally rise more due to operating leverage. However, the reverse is also true. So the mining stocks will be more volatile than the underlying commodity.

Why Invest in Commodity Equities

  • They provide returns comparable or better than a general equity index over the long run. For example in the 15 years ending 2013, natural resources stocks based on the S&P North American Natural Resources Index) returned 10.04%/yr. vs. 6.18%/yr. for commodities (as measured by the GCSI Commodities Index).*
  • Commodity equities have outperformed commodities in:*
    • 117 out of 173 of the past 3 year rolling return periods, or 68% of the time
    • 109 out of 149 of the past 5 year rolling periods, or 73% of the time
    • 84 out of 89 of the past 10 year rolling periods, or 94% of the time
  • Unlike commodities futures and related investment vehicles that hold them (ETFs, ETNs and mutual funds), the equities represent a stake in a corporation. They have intrinsic, tangible underlying value and they pay dividends.
  • Generally speaking, the equities will rise when the underlying commodity price rises, so they are a play on rising commodity prices.
  • Given the profligate monetary policies of major world nations and future demand from emerging economies such as China, I believe that commodity prices will rise significantly over time. Commodities represent “hard assets” that will benefit from inflation and currency debasement.

Problems with Investing in Commodity Equities

  • They are not a “pure play.” The movements of the stocks don’t necessarily track the movements of the underlying commodities.
  • They do not have as much portfolio-diversification benefit as the futures-based products because they are correlated more with the overall stock market than with the underlying commodities.
  • Commodity equity performance is influenced by a number of factors unrelated to the commodities themselves, such as the cost of production, overall stock market trend, management effectiveness, the degree of operating leverage, and how much hedging the commodity producer utilizes.
  • They have inconsistent downside protection in bear markets.

Key Takeaways – Commodity Equities

  • In my opinion, it is probable that irresponsible money printing worldwide will eventually come home to roost, boosting commodity prices and commodity equities in the long run.
  • Historical performance of commodity equities and world demand also argue favorably for investing in them.
  • All the evidence leads me to conclude that commodity equities are a more attractive investment than commodities (futures-based vehicles).
  • A position in select commodity-sector equities (to supplement the holdings contained in a general equity index) will help protect investors from inflation and currency debasement over the long run and provide portfolio diversification and better risk-adjusted returns.

*Source: Prudential Investments: Insights on Investing in Commodities


This is a controversial asset class. Legendary investor Warren Buffet does not believe in investing in gold. However, many professional investors, including competent and conservative investment advisors believe gold is an essential component of an investor’s portfolio.

For six thousand years gold has been considered a store of value and medium of exchange, the definition of money. When the Roman Empire dominated Europe, a gold coin bought a fine men’s suit. Today this is still true. Gold is a store of value. It is difficult to debase and is very rare, compact and nearly indestructible.

Here are the reasons I believe you should have gold in your portfolio:

  • Given major countries’ easy money policies, gold provides protection against currency devaluation and inflation, especially hyperinflation.
  • It represents a store of value. Given low interest rates, there is little opportunity risk in carrying gold.
  • Gold also provides protection against black swan events, e.g. wars, natural disasters and financial crises such as occurred in 2008.
  • Gold has positive diversification effects in a portfolio. Even though gold is by its nature a more volatile asset than bonds, by swapping out a small amount of bonds for gold, there is a tangible reduction in potential long-term portfolio losses.

There are arguments against owning gold:

  • Gold has no inherent income producing value or yield from an economic standpoint.
  • From 1802 – 1997 gold generated virtually the same return as inflation, hence did not grow a portfolio in real terms. (However from 2000-2011, gold gained 450% while inflation ran at about 2.5%/yr.).
  • It had a major 10-year bull run to its peak in 2012 and may never return to those levels.
  • There are significant deflationary forces in world economies that may depress the price of gold.

Given all factors considered, I believe it is wise to hold 5-10% of total portfolio assets in a combination of physical gold, gold ETFs and gold mining stocks.

For more insight, see: Market Realist: Retirement pick: Gold and the long-term investor and Evanson Asset Management: Alternative Asset Classes and Why Gold Will See $2,000.

Gold Mining Stocks

The following arguments support the inclusion of gold-mining stocks in an investment portfolio:

  • Unlike gold bullion, mining stocks produce economic value by profiting from the extraction and processing of metals. Shareholders receive this value through the distribution of profits via dividends.
  • Precious-metal mining stocks have historically realized low correlations to the broad U.S. stock market and the U.S. Treasury bond market. Precious-metal mining stocks historically have been volatile. While the returns of precious-metals equity have been lower than the broad market, the characteristics of low correlation and high volatility are features which provide for positive returns in a rebalanced portfolio. Prominent investor/author William Bernstein finds that disciplined rebalancing of precious metals equity has historically added a five percent bonus to precious-metals equity returns.
  • Bernstein also notes that precious-metals equity requires a very long investment horizon, as returns of this sector can have very long periods of poor performance.
  • Investors who include gold bullion in their asset allocation usually do not consider precious-metals equity as a suitable replacement for bullion in a portfolio. In this view, physical gold provides an insurance function against disorder in currency, equity and bond markets that precious-metals mining stocks cannot reliably provide.

See: Bogleheads: Precious Metals Equity and Efficient Frontier: The Expected Return of Precious Metals Equity

Buyer Beware!

There are other types of investments that I haven’t covered here and financial institutions are constantly innovating with new products. I’d like to wrap up this section with a word of caution on what to avoid:

  • “Hot” investments that have been doing well lately.
  • Private investments offered via friends/family, e.g. private equity in oil wells, new business start-ups, or other “special situations” not available to the general public.
  • Tips on individual stocks or IPOs.
  • Land or other undiversified and illiquid investments.
  • Insurance products, especially variable annuities.
  • Options, derivatives or other speculative products.
  • Anything that sounds too good to be true – because it usually is!

Go to the Next Article: Designing Your Portfolio