In Search of the Perfect Investment Portfolio; It’s much harder to find than conventional wisdom would suggest.

In Search of the Perfect Portfolio

It’s much harder to find than conventional wisdom would suggest.

BRETT ARENDS 

Dec. 27, 2013 6:06 p.m. ET

If you’re looking for an investment portfolio that you could just forget about—and which would still earn good returns in any environment—what would you put into it? It is surprisingly hard to find a good answer—especially in the current situation, with stocks and bonds seeming so expensive.Investment advisers and managers usually recommend some variant of 60% stocks and 40% bonds (with fewer stocks and more bonds as you get older). The portfolio should be rebalanced at least once a year—selling some of what has done well to buy more of what has done poorly, restoring the target proportions.

The theory is that when stocks do badly bonds will do well, and vice versa. But the theory is flawed.

Historically, this portfolio has only succeeded when stocks, or bonds, or both, have been reasonably valued or cheap. In the past, if you had invested in this portfolio when stocks and bonds were both overvalued, it proved a very poor deal.

Using data on stock and bond returns from New York University’s Stern School of Business and inflation data from the Labor Department, I looked at how such a portfolio performed in the past when measured in real, inflation-adjusted dollars.

It lost a third of its value from 1928 to 1932, and it lost value over two longer periods as well, from 1936 to 1947 and from 1968 to 1982—even before deducting taxes and costs. In reality, most investors would have done very badly indeed.

What about now?

U.S. stocks today look ominously expensive by the same measures that flashed red in 1928, 1936 and 1968. The S&P 500, for example, now trades at 25 times the past decade’s per-share earnings, according to data tracked by Yale University finance professor Robert Shiller. The historic average is 16 times.

Nonfinancial stocks now trade for one times the value of company assets, a measure known as the “q,” according to Federal Reserve data. The historical average is about 0.6 times, according to London University finance professor Stephen Wright.

Back-testing suggests that both of these measures have been powerful predictors of future stock returns since the 19th century. Bond yields, meanwhile, are near historic lows due to the “quantitative easing” policies of the Federal Reserve.The 10-year Treasury note yields just 3%, and corporate bond yields are near their lowest levels since the early 1960s.

Yes, inflation seems benign. But it always does when bond yields are low. Bond investors get hit by unexpected rises in inflation. Further Fed “tapering” of its bond-market interventions, which begins next month, also could hurt bonds.

Based on the best estimates of GMO, a Boston money-management firm with $112 billion in assets, such a balanced portfolio of 60% stocks and 40% bonds is likely to earn meager returns over the next seven years or so.

What are your alternatives?

Market historian Rob Arnott, chairman of money-management and advisory firm Research Affiliates in Newport Beach, Calif., says that the ultimate “universal” passive portfolio—one designed to weather all environments—would be equal parts real estate, commodities, stocks and bonds, rebalanced periodically to restore the initial proportions. His suggestion was inspired by the investments of Jakob Fugger, the German Renaissance financier.

He adds that investors should buy global investments—including emerging-market stocks and bonds—and not merely those of the U.S.

Alex Shahidi, a financial adviser at Bank of America Merrill Lynch in Los Angeles, argues for equal proportions of stocks, commodities, long-term government bonds and inflation-protected government bonds.

Commodities and real estate might do well in times of unanticipated inflation, offsetting any losses on bonds (and stocks).

Others say investors should own natural-resources stocks instead of commodities, because of the transaction costs involved in funds that use commodity futures. Still others say investors include gold.

All these suggestions depend on hypotheses. There simply aren’t enough data for multiple asset classes over long periods to be certain. (Inflation-protected U.S. bonds, for example, didn’t exist before the 1990s.) And existing data might not be that useful. Some markets, such as gold, have been changed fundamentally by the influx of retail investors.

Andrew Smithers, a financial consultant in London, looked at passive portfolios in detail a few years ago on behalf of the endowment committee of a college at Cambridge University in England. He argues for a simple portfolio of stocks and cash (such as short-term deposits), rebalanced annually. Cash is a better counterweight than bonds, he found, because it was less correlated to stocks—and less vulnerable to inflation.

Mr. Smithers says the best long-term performance came from varying the proportion of stocks in the portfolio from year to year, between 60% and 100%. The ratio depends on how expensive stocks are based on long-term measures such as Mr. Shiller’s 10-year price/earnings ratio or the “q” ratio.

No past research can ever be an infallible guide to the future. Mr. Smithers’s analysis offers the merits of simplicity and common sense.

Reason suggests two potential changes. The first is to invest in a global portfolio of stocks rather than merely in the U.S. The second is to include inflation-protected Treasury bonds, or TIPS, as well as cash in the nonstock portion, although Mr. Smithers demurs.

Simplicity is a virtue. But finding the right simple answer isn’t as easy as it might sound.