Asset Allocation: Why Investors Should Diversify Beyond Stocks

Alexander Green
by Alexander Green, Chief Investment Strategist Wisdom of Wealth Wisdom of Wealth

Asset Allocation: Why Investors Should Diversify Beyond Stocks

by Alexander Green, Investment Director

Monday, April 6, 2009: Issue #972

As someone who has spent more than two and a half decades as a research analyst, investment advisor, portfolio manager and financial writer, I've often felt the most important question an investor or trader can ask himself is, "What if I'm wrong?"

This is done too seldom, in my experience. And that's unfortunate. Because when investment lessons are learned the hard way, it can be painful... if not devastating.

For example, when the market was flying high a couple of years ago, many investors became complacent. They blithely assumed that the market might hit a pothole here and there, but overall it would be a relatively smooth ride higher.

The long-term history of the market, of course, suggests something very different. But you didn't need to be a market historian.

All you really needed to do was stop and ask yourself, "What if I'm wrong?" Do this and the answer - the right one - generally appears. You should diversify beyond stocks - using asset allocation - and into bonds, inflation-adjusted Treasuries, certificates of deposit, or even precious metals or coins.

Why Asset Allocation Works

Using asset allocation - which is exactly what we've been recommending for years - would not have left you entirely unscathed by the recent market meltdown. But you would be in far better shape than the many thousands of investors who still haven't summoned the courage to open their brokerage statements.

Or take individual stocks:

  • You might have believed that you were invested in wonderful blue-chip companies that were the backbone of the world economy, giants like Citigroup, General Motors, Bear Stearns or AIG.

  • Indeed, for decades each of these companies bestrode their markets like a Goliath. You might recall, however, that Goliath didn't fare so well in the end. And neither did these guys.

  • You couldn't have known that in advance, of course. But you could have run a trailing stop behind each of your stock positions - as we've been recommending for years - protecting both your profits and your capital.

Would that have kept you from losing money? Perhaps not in every case. But using a proven sell discipline like this would certainly have kept you from riding these fallen angels into the ground.

All you had to do was ask yourself, "What if I'm wrong about the long-term viability of these companies?"

That doesn't mean, of course, that you should never have bought them. But you would have tempered your enthusiasm by using a trailing stop. That way you would have owned these stocks only as long as they were trending up - or at least treading water - and found yourself out of them when they began to seriously backslide.

This didn't require some magical foresight, by the way. What it required was humility.

The Starting Point For All Intelligent Investing

It required you (or your financial advisor) to understand that no matter what the market - or any particular company - had done in the past, no one can accurately and reliably predict the future. This, in my view, is the starting point for all intelligent investing.

I was reminded of this at Investment U in St. Petersburg, FL two weeks ago, where I had the opportunity to mingle with a couple hundred investors from around the country.

Most of them were more sophisticated investors. They had been around through several market cycles. They had made a lot of money in the past. And - like the rest of us - got bruised more than a little during the recent bear market.

Talking to many of them, I sensed extreme skepticism about the outlook for the market. Some confessed that they were unremittingly bearish. I spoke with just a handful who were eagerly investing in stocks right now.

And maybe that's a good thing. Maybe after 15 months of recession, the economy is still a long way from recovery. Maybe the market will test the lows of early March or even fall substantially lower.

Maybe.

But before you sell all your stocks and stock funds, quit reinvesting your dividends, pile into low-paying cash investments or turn your back entirely on fresh opportunities in the market, stop and ask yourself the one simple question that guides and instructs all investors:

"What if I'm wrong?"

Good investing,

Alex Green

Today's Investment U Crib Sheet

Over the past week we've been reporting on the highlights from our Investment U Conference. And within those days, we touched on a number of incredible opportunities for investors to look at right now.

For example, on Monday, we looked at a number of ways investors can add gold to their portfolios.

There's a few other ways for investors to own gold...

  • Physical Gold: Rick holds his physical gold in a bank safe deposit box. His is located at his half-year residence of Canada in the bank of Nova Scotia.

  • Paper Gold: The SPDR Gold Trust ETF (NYSE: GLD) is a good option for investors who need liquidity with their gold assets. You can buy and sell this ETF like any stock on the market. Which also means you can sell it short, if you believe it will fall.

  • Gold Coins: Gold coins are an easy way to own gold in your portfolio. Unfortunately, because of the demand, you'll be paying a hefty premium to purchase them. This was discussed a little in our Panel Discussion, and we'll have more for you on that dialogue tomorrow.

  • Gold Futures: Gold futures may be an excellent option for some. However, he stays out of gold futures because he believes it's too volatile. Rick believes silver futures are even worse, like gold futures on steroids.

  • Gold Stocks: Gold producers trade between 1.7 and 2 times the net present value of their cash flows they could generate. It's called the warrant on the gold price. Basically the market has assigned a large "growth" premium to a mining business - where the business gets smaller every day. There's less and less gold to mine.

We also discussed a number of gold stocks and "prospect generators" - minerals exploration companies - that Rick Rule and company suggested. You can read more about these companies at "Golden Opportunities and Your Options."

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