That question, right there, is what diversification really boils down to—a lot of financial planners say things like, you need twenty stocks, or you need thirty stocks, or whatever it may be—but that kind of stuff is just shorthand meant to give a kneejerk response to a Yahoo! or MSN Money audience that they don’t want to actually have a specific, detailed conversation with.
When I think about diversification, this is what enters my mind: U.S. bonds, real estate, small-cap stocks, and large American individual stocks. There are other things you could add if you wanted to get really niche: international government bonds, midcap stocks, international stocks of all varieties, and high-yielding corporate bonds in a few select cases, but that’s based on your own particularities of what you’re trying to do.
Here’s how I’d think through each one. First you have the staple of security for all long-term planning: Thirty-year Treasury bonds. For most of the 1990s into the early 2000s, you could get yields between 5% and 8.5% just by owning completely safe, rock-of-gibraltar bonds issued by the United States government. You could see the immediate appeal of such an allocation: you could be receiving a guaranteed $417 to $708 every month from intelligently putting together a $100,000 portfolio of thirty-year Treasuries over time.
It wasn’t until the September-December 2008 stretch that US Treasuries started to offer comically low yields, as the thirty-year figure fell from 4.30% to 2.69% in that short time frame, jolting families approaching retirement that had yet to build a portion of their portfolio earmarked for US bonds. The good news, even though it may not have been evident at the time, is that stocks were incredibly cheap and offering very high dividend yields at the time, so at least you had something to work with. My guess is that the thirty-year treasury figure will eventually normalize towards its historical 6% range, and even though recency bias is a powerful mental model that affects how we perceive things, we will again see rates that high even if it takes ten to fifteen years.
The second thing to look at is real estate: there, if you have two options: if you want the high yield and are willing to deal with the hassle, you can buy an individual property in a community that tends to have high employment and even maintained stable home prices throughout the recession, and the rule of thumb here is this: you aim for a 10% cap rate, and conservatively estimate that half of that will enter your pocket net of expenses. In other words, with a $200,000 house, you assume $20,000 in annual rent at a rate of $1,667 monthly, and you assume that you can use $833 of that to live on.
Or, there is REIT investing, which is an awesome development. There, you can buy things like Realty Income, which yield 5%, and put you in a remarkably close position to what you might be as a landlord net of expenses (although keep in mind that my estimates above were conservative, so you could have situations where you end up pocketing 75-80% of the monthly rent). Realty Income has been raising its dividend every year since being on the stock exchange in 1994, and has been paying monthly for decades before its listing on the major American stock exchange, and it proved its street cred to a lot of people when it raised its dividend during the financial crisis. Essentially, you would want a portfolio of REIT holdings that shared Realty Income’s characteristics.
Next, there are small-cap stocks. If you don’t take to what I say about large American stocks that is often the focus of my writing here, far and away the most intelligent thing you can do is purchase a small-cap index fund through an outfit like Vanguard. The data for small-cap American stocks over the long haul is compelling. According to Ibottson and Associates, small-cap American indices returned 12% annually from 1926 through 2006 while a large-cap basket of American stocks returned around 10%. Buy regularly, hold, and reinvest into a small-cap index fund is a great way to build significant wealth in a way that doesn’t get a lot of attention in the American finance media.
A small-cap index fund, through perseverance and relentless additions, could be a retirement fund in its own right. Imagine if you met Vanguard’s minimum initial $3,000 investment and then added $200 each month for thirty years to its small-cap index, reinvesting the dividends along the way with the expectation that you would capture the historical rate of compounding at 12%. What does your life look like at the end of thirty years? That would be $800,000 in its own right. As a historical aside, Wal-Mart’s growth played a huge role in the outperformance of small-cap indices during the 1970s, as it was growing at over 30% annually. A lot of funds were reluctant to sell that; in fact, T Rowe Price management subsequently adopted a “Wal-Mart Rule” in their prospectuses that permits them to continue holding a security that outgrows the size typically associated with the fund. I found that to be an intelligent common-sense adjustment.
And then there are the large-cap American stocks that I frequently discuss here. When you are taking diversification seriously, and are investing in American stocks in a “I can’t lose this money permanently” kind of way, then you need to apply some strict rules that could exclude some very lucrative opportunities. It means you can’t in banks, and you can’t invest in companies with a tech component. The debt to equity risk of overleveraging with banks, and the risk of product obsolescence with tech companies, is too great to make them a candidate for this kind of portfolio construction.
Instead, you focus on the companies with the most obvious products that will be with us many, many years from now: Coca-Cola, PepsiCo, General Mills, Kraft, Johnson & Johnson, Brown-Forman, Nestle, Hershey, Colgate-Palmolive, Procter & Gamble, and 3M, to name the obvious candidates for “permanent capital” consideration. Ideally, you’d want dividends that have been going up for at least three decades without interruption, and a ten-year earnings per share growth rate of at least 5%. Sure, you make some common-sense exceptions (e.g. Kraft and General Mills don’t have perfect records of dividend growth, but they have been generating profits for over a century and sell a diversified collection of products that people can’t live without out—the point is, when you make an exception, it’s important to have a good reason why), but those are good parameters to apply for super conservative investing.
When you build a collection of wide-ranging assets like that, it’s essentially impossible to fail. You can’t do anything more to protect yourself. You have stable bonds backed by the taxing power of a $14 trillion economy. You’d have real estate, a product that’s been in demand for thousands of years and generates reliable income as long as you are a bit deliberate about your selections. You have a basket of the small-cap universe, which has an excellent data-supported history of delivering superior returns. And then you have the American behemoths, with excellent records of paying out shareholders, and selling products that we can clearly understand why they are successful at growing profits in all environments. That’s what defensive allocation looks like; that’s how you protect yourself.
Originally posted 2014-07-14 08:00:08.