The “Life Cycle Investment Hypothesis”

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Physicians Returning to Zero?

[By Somnath Basu PhD, MBA] 

How have your investments done over the last three years? If you were to ask doctors, or the myriads of people who are or even pose as professional financial advisors, they would generally say that it would depend on how well your portfolio was diversified. By this jargon, they would mean how your money (in what proportions) was invested among various asset classes such as stocks, bonds, commodities, cash etc. The more it was spread out around various asset classes, the safer they would have been.

To see how safe (or how risky) your portfolio was over the last few years, it’s useful to view how these asset classes themselves fared over this time period. That is what is shown in the next chart where the following asset class performances over the last few years are shown. The chart shows the performances of stocks (S&P 500 shown by the symbol ^GPSC, in red), bonds (symbol IEI, Barclay’s 3-7 Year Treasury Bond index etf, in light green), Commodities (DBC, Powershares etf, in dark green), Long dollar (UUP, Powershares long dollar etf, in orange; this fund allows speculating on the dollar going up against a basket of important currencies; whenever the world financial markets are in turmoil, this index generally goes up as investors around the world seek the “safe haven” status of the dollar.

Alternately, note that this index value will also typically rise when the domestic economy is in a sound condition and both domestic and international investors favor the U.S. financial markets) and the short dollar (UDN, the Powershares inverse of UUP). Note that the “Cash” asset class has been left out and returns on cash (or money market funds) have been close to zero the whole time.

There are a few startling observations from this period. The first part that arrests the eye is how commodities performed over this time period. If your portfolio was heavy in this sector, you had a heck of a ride these last three years. If you had a lot of stocks as well, heck, your ride just got wilder. As can also be seen from the picture, healthy doses of bonds and currencies would have made your ride that much smoother.

On the other hand, what is additionally startling to observe is that we all started this period close to zero returns in the beginning of 2007 (around March 2007) and in June 2010, we are all converging back to zero returns. No matter how you were diversified, you either took a smooth ride (well diversified portfolio) from a zero return environment to a zero return environment or a wilder ride. That is why diversification is so important. Another way to gauge your diversification benefit is to use a two-pronged system.

The first is what I refer to as the “monthly statement effect”. When your monthly financial statements come in, you first observe the current month’s ending balance, then the previous month’s ending balance and then have a great day, a lousy day or an uneventful day. Depending on how good or bad (how volatile the ride) the monthly effect is, it may last for much more than just a day, maybe days. The second piece is your age.

Life Cycle Investment Hypothesis

As you grow older, you ask yourself how wild a ride can you tolerate at this point in your life? Hopefully, as you age, this tolerance level should show significant declines. If it does, you are then joining a rational investment group practicing a “lifecycle-investment hypothesis” style. Finally, did anything do well during this time? Yes, and surprisingly from an asset class whose underlying asset is shaped too like a zero – mother earth and real estate. Having some real estate in your investment basket (another important diversification asset) would not only have smoothed your ride but would have made your financial life so much more pleasurable. Just take a look at this picture below (FRESX, an old Fidelity’s real estate index fund) which says it all.

Assessment

Even in the darkest days of falling real estate markets of 2008, this fund produced a positive return. Of course many other real estate indexes lost their bottoms; thus finding these stable indexes in all asset classes are well worth their salt. That is, if it is time for you to diversify.

Conclusion

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