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March 12, 2020

Asset Allocation in a Low Interest Rate Environment

For months—years—I’ve been extolling the virtues of portfolios that are primarily comprised of bonds. Especially in retirement.

Bonds provide necessary diversification. Stock-only portfolios are abnormally volatile and lead investors to make suboptimal decisions. Bonds may end up reducing returns, but you are more than compensated by the reduction in risk.

This is the argument I was making a year ago when we were selling the Bond Masterclass. I talk quite a bit more about bonds in the red-alert call with me and two other analysts that Mauldin Publisher Ed D’Agostino put together. (Watch it here.)

People gave me a lot of crap about the Bond Masterclass. I heard all about how IRRESPONSIBLE it was to PROMOTE bonds in a LOW INTEREST RATE ENVIRONMENT. And then interest rates went even lower, as stocks went down a lot. So people with a bond-heavy portfolio would have been… happy. Or at least, they would have slept well at night.

Never mind the fact that because of convexity effects, when interest rates are low and go even lower, bond prices go up a lot. Last week, when the Fed cut rates 50 basis points, the long bond was at one point up more than five points in a day.

And people say that bonds are boring!

Anyway, the point of putting bonds in your portfolio alongside stocks is for the diversification benefits. When interest rates are very low (close to zero), some of those diversification benefits start to disappear. This makes things very hard. If stocks are volatile, and bonds are no help, where do you put your money to mitigate volatility?

There aren’t many options.

Your Options

Here are your options:

1. Commodities (especially gold)

2. Real estate (either physical real estate or REITs)

3. Cash

4. Misc., like collectibles and art.

Let’s start off by saying that art and collectibles generally do a pretty poor job of providing diversification. They are cyclical and generally move with stocks.

I always like cash, and everyone should have 10–20% cash in their portfolio at all times. The good thing about cash here is that, with interest rates at such low levels—perhaps even negative—the opportunity cost of holding cash is low.

Kinda dumb to hold cash when interest rates are 8%. Makes more sense when rates are at 1%.

But I really want to talk about commodities and real estate, because those are the big diversifiers.

Commodities are tough. It’s tough to sell something that has a negative cost of carry, like commodities do. Also, it’s tough to sell something that’s been going down for a long time, like commodities have.

We’re currently experiencing a deflationary shock with coronavirus, but my suspicion is that the deflation is a headfake. If you want to have the inflation/deflation argument with me, please leave it in the comments where I won’t read it.

Within commodities, though, gold has a special role. Its whole purpose is to provide diversification, because it’s the anti-stock and anti-bond. It’s the alternative to traditional finance. And the correlation is typically zero, or negative (or it used to be).

I think that it makes sense to move away from bonds as a diversifier and toward gold.

That’s hard for people to swallow. I proposed this to my mom who thinks gold is risky. It is certainly “riskier” than the bonds she is holding, if you define risk as volatility. But again, you add something with low correlation to stocks and bonds to the portfolio, and it is going to improve the risk characteristics.

The same is true for real estate, although less so. The nice thing about real estate is that it also provides income, which gold doesn’t (although again—in a low rate environment, the opportunity cost of holding gold is practically nonexistent).

Real estate should perform well in an inflationary environment, and it should also provide decent diversification benefits.

The Portfolio

So we want a portfolio with less stocks, less bonds, some cash, some gold, and some real estate. What does that look like?

The 20/20/20/20/20 portfolio.

20% stocks

20% bonds

20% cash

20% gold

20% real estate

This is the benchmark we should be using for the next ten years and beyond.

These are the challenges we face when interest rates get really low. These are the things we have to think about. I don’t want to get into the morality of lending to the government at 1.3% for 30 years. There are plenty of pinheads who do that on Twitter.

We’re faced with the very practical concerns of how you 1) save for retirement and 2) protect against inflation in a low-interest rate environment.

As for the inflation part, nobody has had to think about that for a long time, but they might soon.

And with all these thousand-point market swings, your more immediate concern is probably about your nest egg. If so, then you really want to watch the video of the red-alert call with Ed, Robert Ross, Chris Wood, and myself.

With the insanely fast pace of current events—from the coronavirus scare to the Russian-Saudi oil standoff—we want to give readers like you some reassurance and show you that there are amazing profit opportunities out there. Even in a falling market like this.

If you can manage to keep your wits about you, this could be one of the best times to buy low in a decade. We even provide a “shopping list” for you in the video with investments we’re closely watching right now. So check out that video now.

Jared Dillian

ETF 20/20: Your solution for intelligent ETF investing. Jared’s introductory service, helps investors use ETFs to make more money in the markets with less volatility. ETF 20/20 is a newsletter for every investor—order your subscription now

Other publications by Jared Dillian: Street Freak: Jared’s monthly newsletter for self-directed stock pickers. Learn how to pick and trade trends, and master your inner instincts here. The Daily Dirtnap: Want to read Jared every day of the week? Hear his daily thoughts on the markets, investor sentiment, central banks, and a dose of dark wit. Thousands of sophisticated investors, Wall Street traders, and market participants read Jared’s premier service, The Daily Dirtnap. Get it here.

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