A Little Bit Of Diversification Helps A Lot

During the long bull market in bonds after 1982, the idea that government bonds are always the safest option took hold among many Americans. Investors saving for short-term goals, retirees, and others with low-risk tolerance often limit themselves to bonds. That is a big mistake. It turns out that a little bit of portfolio diversification can do a lot to raise your returns. What is more, small amounts of gold and stocks can actually reduce the risk of an all bond portfolio.

Since 1971, a portfolio consisting entirely of 10-year treasury bonds has underperformed a diversified portfolio with 10% stocks and 10% gold by about one percent per year. That extra percent is not a relic from gold’s incredible performance in the 1970's or the 1990's stock bubble. Between 2010 and 2017, a little bit of diversification was still enough to earn about one percent extra each year. 

One percent might not seem like a lot, but remember that the long run return of stocks is less than four percent higher than the long run return for bonds. To get that extra four percent, investors with stock only portfolios run the risk of dramatically higher losses than bondholders. One naturally wonders what sort of risk bondholders face when they add small amounts of stocks and gold to their portfolios.

It turns out that a little bit of diversification has been a free lunch for investors. Since 1971, a diversified portfolio consisting of 80% 10-year government bonds, 10% gold, and 10% stocks never lost more than seven percent in any given year. Bondholders repeatedly endured more significant losses during the last decade. The total return for 10-year treasuries was -9% in 2013 and -11% in 2009. If we judge risk by worst year performance, then a diversified portfolio has been less risky than holding only 10-year government bonds.

The most important long-term benefit of a little bit of diversification is protection from inflation. Gas prices are near their highest levels in years, and inflation is becoming a threat again. Gold directly benefits from inflation, and stocks can rise with prices too. Bonds now offer such low interest rates that they can barely keep up with today’s modest inflation. If we see a return to the double-digit inflation of the seventies, a little bit of diversification will help a lot more. 

Whether you want protection from inflation or you just want higher returns, adding small amounts of stocks and gold to your bond portfolio is one of the best options available today. You might have to wait a long time to hear that from anyone in the bond industry, but there’s no reason to delay. Diversifying into gold and stocks can reduce the risk of holding bonds, so the real danger is doing nothing while rising inflation reduces your returns.