What Investments Do You Need?

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.