While working on a new presentation about portfolio strategies, it occurred to me that there is an important question I should address: What investments does an individual investor need in their portfolio? Not specific names, but rather what types of investments. It’s a question that is not necessarily easy for many investors to answer. It’s also a question that many (but not all) investment companies, financial advisers and sales people are often too eager to answer in a way that is beneficial to their compensation.

The most universal answer I can give is common stocks, bonds and cash. These are the three core assets nearly every investor should use as the cornerstones for their portfolios. Stocks have historically provided the best long-term total returns, thanks to price appreciation and dividends. Bonds offer income and a ballast against the volatility of stocks. Cash is ideal for shorter-term liquidity.

Combined, these three asset classes provide good diversification, especially when properly allocated to. While such a mix may sound overly simplistic, getting this basic allocation right over the long term is a high hurdle for many investors. Aversion to losses, too much emphasis on current news and data and overconfidence all cause investors to fail at simply sticking to a well-thought-out mixture of stocks, bonds and cash. Focus first on this basic mix and then, if you have the discipline or particular needs, consider other types of investments.

In order of importance, I would put real estate investment trusts (REITs) next. These real estate investments have provided total returns similar to those that small-cap stocks have realized since the 1970s, but they don’t always move in lockstep with stocks overall. As such, they offer the dual benefit of diversification and favorable returns. Their relative lack of tax efficiency makes them best suited for tax-advantaged accounts (e.g., IRAs, Roth IRAs, etc.).

Annuities can play a role in retirees’ portfolios. The big advantage of annuities is their guaranteed stream of income. As long as the contract holder stays alive, a stream of income will be paid. They won’t make a person wealthy, however, and generally should only be used by those in or nearing retirement. Annuity buyers can encounter overly aggressive sales pitches and high commission products, so it’s important to be prudent and ask questions. Focus on immediate and deferred (including qualified longevity annuity) contracts. Tread very carefully with variable annuities, or simply avoid them outright. Keep in mind that the more your Social Security and pension benefits cover your fixed expenses, the less you need annuities.

Like annuities, life insurance can work well when properly used. Plain-vanilla term life insurance is good for those seeking to protect their immediate families should the unfortunate occur during their working years (e.g., being in fatal car accident before the kids are sent off to college). Whole and universal life policies can make sense from an estate planning perspective for those who are affluent. Be mindful of costs, ask lots of questions and make sure you understand what might cause the policy to lapse. As is the case with annuities, be careful about who you buy from.

There is no doubt that commodities can add to a portfolio’s diversification. Their actual benefit, however, is not anywhere near to the benefit realized by simply getting the basic mix of stocks, bonds and cash right over the long term. Hence, their low ranking in terms of importance. If someone were to allocate to commodities, I would suggest focusing first on gold and master limited partnerships (MLPs). Gold is not correlated to most other investments over the long term. How correlated it is to inflation is even debatable. MLPs are a play on energy usage. MLPs are more complicated from a tax standpoint—a factor that should be taken into consideration. While futures contracts and certain exchange-traded products can give more direct exposure to energy prices, I think avoiding dealing with constant contract expirations is a better strategy for most investors.

There are obviously other asset classes and types of investments to choose from. Most investors can safely avoid them. While some of you may have had/are having success with options, currencies, hedge funds, private equity and other investments not mentioned here, they are what I consider to be either speculative, only suitable for certain groups or discretionary.

• How Investors Miss Big Profits – Data from research firm DALBAR shows how investors’ behavior leads them to underperform the very mutual funds they invest in.
• Retirement Readiness Is Being Assessed in the Wrong Manner – In this interview about retirement income, Moshe Milevsky gave a framework for determining how much of an allocation to annuities is warranted.

• Stock Market Retreats and Recoveries – Stocks have experienced a drop of 5% or more approximately once every six months, but recoveries have generally been quick, as Sam Stovall explains.
• Model Shadow Stock Portfolio: Three New Stocks Added – The proceeds from the latest deletion were used to add three new stocks in this real money portfolio.

Third-quarter earnings season will “officially begin” with JPMorgan Chase & Co. (JPM) being the first Dow Jones industrial average component operating on a calendar-year basis to report earnings. The financial conglomerate will report Thursday. Also reporting next week are eight S&P 500 fellow members: BlackRock Inc. (BLK) and Fastenal Co. (FAST) on Wednesday; Citigroup Inc. (C) and Delta Air Lines Inc. (DAL) on Thursday; and Bank of America Corp. (BAC), JB Hunt Transport Services Inc. (JBHT), PNC Financial Services Group (PNC) and Wells Fargo & Co. (WFC) on Friday.

The week’s first economic report will be the Labor Department’s August JOLTS report, released on Wednesday. The minutes from last month’s Federal Open Market Committee (FOMC) meeting will also be released on Wednesday. Thursday will feature the September Producer Price Index (PPI). Ending the week, the September Consumer Price Index (CPI), September retail sales, August business inventories and University of Michigan’s October preliminary consumer sentiment survey will be released on Friday.

Five Federal Reserve officials will make public appearances: Minneapolis president Neel Kashkari and Dallas president Robert Kaplan on Tuesday; Chicago president Charles Evans on Wednesday; governor Jerome Powell on Thursday and Friday; and Boston president Eric Rosengren, Chicago president Charles Evans and Dallas president Robert Kaplan on Friday.

The Treasury Department will auction $24 billion of three-year notes and $20 billion of 10-year notes on Wednesday and $12 billion of 30-year bonds on Thursday.

The percentage of individual investors describing their six-month outlook for stocks as “neutral” is at its lowest level in nearly six months. The latest AAII Sentiment Survey also shows increases in both optimism and pessimism.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 2.3 percentage points to 35.6%. Even with the increase, optimism remains below its historical average of 38.5% for the 35th time this year.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 6.3 percentage points to 31.6%. Neutral sentiment was last lower on April 26, 2017 (30.2%). The drop follows what had been a nine-week high. This is the 23rd consecutive week that neutral sentiment is above its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 4.1 percentage points to 32.8%. The increase puts pessimism back above its long-term historical average of 30.5% for the first time in four weeks.

This is the seventh time in the past 10 weeks with a bearish sentiment reading above its historical average. Since the start of the year, there have been 23 weeks with an above-average level of pessimism. In contrast, bullish sentiment has only been above average in five out of this year’s 40 weekly sentiment readings as noted above.

Political drama in Washington remains at the forefront of many individual investors’ minds. (Many are skeptical about the prospects of tax reform being passed, as the answers to this week’s special question show.) Valuations are also playing a role, creating concern among some about stocks being overpriced and potentially leading to a drop in prices. Others, however, are encouraged by the continuing economic and earnings growth.

This week’s special question asked AAII members to describe how their sentiment toward the stock market is being influenced by the prospects for tax reform. The majority of respondents (57%) said their sentiment is not being influenced. Many in this group either expressed skepticism about the likelihood of tax reform passing or are waiting to see what legislation Congress actually passes. Approximately one-third (33%) of respondents said the prospects for tax reform are causing them to be more optimistic about the short-term direction of stock prices. Some of these respondents think the proposed tax cuts will help to boost economic and/or earnings growth, though others in this group said their optimism depends on whether or not the proposal is actually signed into law. About 11% of respondents have a negative viewpoint, with several either criticizing the proposed tax cuts or expressing concerns about the impact the tax cuts will have on the national debt.

Here is a sampling of the responses:

• “I am not optimistic about Congress passing any meaningful reform at this time, consequently I am not giving this much consideration.”
• “I don’t think tax reform will get through without changes and that will dampen growth prospects for the market.”
• “I think that the lower company tax rates will increase earnings and stock prices.”
• “Our economy needs tax reform badly; I am more positive about the market if it passes.”
• “The market is acting positively toward the prospects for tax reform, which may not happen. This could be a problem.”

Bullish: 35.6%, up 2.3 points
Neutral: 31.6%, down 6.3 points
Bearish: 32.8%, up 4.1 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

Equity allocations among individual investors rebounded to a three-month high last month, according to the September AAII Asset Allocation Survey. Fixed-income allocations fell and cash allocations declined modestly.

Stock and stock fund allocations rose 1.9 percentage points to 68.7%. Equity allocations were last higher in June (68.8%). September was the 54th consecutive month that equity allocations were above their historical average of 60.5%.

Bond and bond fund allocations fell 2.2 percentage points to 15.1%. The historical average is 16.0%.

Cash allocations declined by 0.2 percentage points to 16.1%. September was the 70th consecutive month that cash allocations were below their historical average of 23.5%.

The change in allocations occurred as stocks rose last month, while rising yields pushed Treasury prices down. Optimism in our weekly survey also rose above its historical average for the first time since last February.

Even though individual investors list Washington politics and valuations as the primary factors influencing their outlook for stock prices, they don’t view bonds as being particularly attractive either. Many AAII members have previously described the ongoing low interest rate environment as causing them to invest in stocks over bonds. September’s increase in Treasury bond yields was likely not enough to alter individual investors’ perception of interest rates.

Last month’s special question asked AAII members what would prompt them to increase their allocations to stocks. Nearly half of all respondents (44%) said a decline in stock prices and/or a pullback in valuations would prompt them to allocate more to stocks. Many in this group said they are waiting for a correction or bear market to occur. Slightly more than 36% of all respondents said they were either happy with their current allocation or were otherwise fully allocated to stocks relative to their age and/or strategy. Approximately 14% are looking to Washington D.C., particularly for progress on tax reform. About 8% of respondents say change in interest rates and/or the economy would be required for them to boost their equity allocations.

Here is a sampling of the responses:

• “A significant stock market correction.”
• “Nothing, as I’m currently heavily weighted in equities.”
• “Valuations are getting ‘frothy.’ A 10% to 15% correction would grab my interest again.”
• “Nothing, because at my age, I need to keep some money in bonds.”
• “Passage of tax reform and tax cuts.”

• Stocks and stock funds: 68.7%, up 1.9 percentage points
• Bonds and bond funds: 15.1%, down 2.2 percentage points
• Cash: 16.1%, up 0.2 percentage points

• Stocks: 30.2%, up 2.0 percentage points
• Stock funds: 38.5%, unchanged
• Bonds: 2.6%, down 0.9 percentage points
• Bond funds: 12.5%, down 1.3

Take the Asset Allocation Survey.

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