The Awesome Portfolio, part four: The last time we dove into The Awesome Portfolio, we talked about why owning nothing but index funds quietly fail you. This edition, the fix almost everyone reaches for next: adding bonds to build the classic 60/40 portfolio—and why, despite the positives, it still leaves you exposed.

Side note: The Awesome Portfolio is officially out in the wild. THANK YOU to everyone who bought it so far. If you’ve been sitting on it, here’s the link.

The 60/40 portfolio has been around for a while, since the days of Nobel Prize-winners Sharpe and Markowitz. The rationale was that, at the time, there were about $1.50 in stocks outstanding for every $1.00 in bonds, that people should hold that approximate allocation in their portfolios.

The 60/40 portfolio is pretty dang good. So, what’s not to love? Why isn’t this book called The 60/40 Portfolio? 

The Nonsense

Well, I will give you the biggest reason why the 60/40 portfolio has major shortcomings:

It’s made up of all financial assets.

Let me explain. A stock is a security—a claim on future cash flows. It is a financial asset. A bond is also a security—a claim on futures cash flows, also a financial asset. Financial assets don’t like:

• High interest rates

• Inflation

They also don’t like:

• War

• Other natural disasters, but especially war

• Bad politics, high taxes, stuff like that

If you have a portfolio that only consists of financial assets, you are going to be negatively exposed to all of these things. All of your assets will react badly at the same time.

Buy Real Assets

You might be thinking to yourself, if I’m in stocks and bonds, and I’m still not diversified, what other things do I have to buy in order to be diversified? You need to buy real assets. Things that are things. Things that do not pay interest or dividends. Like real estate, and commodities.

Suffice it to say that investing in commodities is a little counterintuitive—stocks and bonds go up over time; commodities do not. Investing in commodities, in some way, is a bearish bet. Let me explain…

In the stock market, if you’re optimistic, you’re betting on companies earning more money over time, which they usually do. In the corn market, if you’re optimistic, you’re betting that farmers will produce more corn than ever—which means that the price goes down. Buying commodities is actually an act of pessimism—you’re essentially saying that these growing methods and technological improvements will stop and go backwards—you’re saying that we will screw things up.

You Never Know!

Joaquín Andújar was a pitcher for the St. Louis Cardinals who was quotable, like a lesser-known Yogi Berra. This is my favorite Joaquín Andújar quote: “You can sum up the game of baseball in one word: you never know.”

You never know!

Some people treat the S&P 500 as an immutable law of physics—it will always go up. We have no knowledge of that! The optimists out there who say that you should just own the S&P 500 index and nothing else are simpletons with not a very big imagination.

This is where faith comes in. People have faith that the stock market will always go up forever, because that’s what it has done in the past. There is no place for faith in investing. You can have faith in other parts of your life but not investing. In investing, you have to be coldly rational and consider all possibilities.

Let me give you another analogy. You have two houses. They are both made of wood, right next door to each other. The probability that they both burn down is actually pretty high! That’s what stocks and bonds are—two houses made of wood, right next door to each other. The same catalyst that will burn down one will burn down the other (like a forest fire). That’s why you want a house in Wisconsin and Washington and Arizona.

Early on in my days of writing my newsletter, I talked about the push-pull between paper and things. Stocks and bonds are paper—they are literally pieces of paper that promise to pay cash flows at some point in the future or be worth something at some future date. The obverse of paper is things, literally things that would hurt if you dropped them on your foot.

You must have some things to go with your paper—and that’s why a 60/40 portfolio is incomplete.

A 60/40 portfolio is a good starting point—I wish more people had that. But even a 60/40 portfolio struggles during periods of high inflation and interest rates. You need some hard things to go along with your paper. Paper is a promise, and sometimes we don’t trust promises.

Adapted from The Awesome Portfolio by Jared Dillian, published by Harriman House. The book is LIVE—grab your copy now!

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Poll

Yep…

As for this week’s question…

Dumbest Thing I Saw This Week

LOL. The Economist will Economist. Here’s Jensen Huang as a wizard:

More thoughts on this—and AI in general—in the September newsletter issue of Street Freak.

And Finally

It’s time for another AMA, and you’re invited…

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Jared Dillian, MFA