Why Stocks May Not Be Enough

Although the stock market has performed well over the past 12 months, lofty valuations and other macroeconomic factors are starting to make many question how much longer the bull market can last. With that comes the question, am I diversifying my portfolio enough?

Stocks form a key part of many investors’ portfolios

For many investors, stocks form a key part of the foundation of their portfolio. One of the standard portfolios for individual investors is the 60/40 portfolio, in which 40% of the portfolio is invested in bonds (typically high-quality government bonds) and the remaining 60% is invested in the stock market. For decades, this formula has provided investors with the combination of reliable annual returns and downside protection. The portfolio returned an average of 8.8% per year, according to Vanguard, and the negative correlation of stocks and bonds meant that dips in the stock market were balanced out by increases in the value of bonds.

However, the usefulness of the 60/40 portfolio may be coming to an end. Several factors, including ultra-low bond yields, the rising threat of inflation and the fact that the correlation between stocks and bonds may become positive, all signal that it may be time for investors to re-think their portfolios.

Stocks have been performing well but remain risky

Over the past 12 months, the stock market has performed extremely well — the S&P 500 is up over 50% relative to this time last year. However, investors who focus just on returns aren’t getting a complete picture of their investments. It’s just as important to understand the risks. In this case, the unprecedented stock market returns witnessed in 2020 and 2021 have been paired with unprecedented market volatility.

To better understand the true impact of volatility on a portfolio, it’s important to consider returns on a risk-weighted basis. A commonly used metric for this is the Sharpe ratio, which is calculated using both the return of an investment above the risk-free rate and the investment’s standard deviation, a measure of volatility. A higher Sharpe ratio implies higher risk-weighted returns, while a lower Sharpe ratio implies lower risk-weighted returns.

Not all investments are created equal, as shown in the chart below. For example, from 1992 - 2020 the mean return of the S&P 500 was 8.0%, while the mean return of privately held real estate was 8.7%. Although an 8.7% return doesn’t seem significantly better than an 8.0% return, US stocks had a Sharpe Ratio of 0.31 compared to 0.81 for private real estate. This implies that private real estate offered a significantly better return than the stock market on a risk-weighted basis.

Even more striking is the performance of US farmland. In the same time period, farmland offered better returns than US stocks on both an absolute and risk-adjusted basis. US farmland returns averaged 11.0%, beating US stocks by a 300-basis point margin.

Mitigating risk through diversification

Diversification can take many forms. First and foremost, investors should consider diversifying within asset classes. In a 60/40 portfolio, investors diversify across a range of stocks and bonds. For example, it’s important to buy stocks from multiple industries and companies. That way, no single event impacts a disproportionate portion of your portfolio. Many investors use mutual funds or ETFs as an easy way of gaining broad exposure to the stock market.

However, as illustrated by the correlation across major asset classes in the table below, it’s even more important for investors to diversify across asset classes. Spreading a portfolio across multiple uncorrelated asset classes reduces volatility and protects returns from exogenous shocks.

For example, US farmland is uncorrelated with most major asset classes, including stocks, bonds, gold and private real estate. During the Great Recession, the entire stock market was down by a significant margin. In contrast, US farmland performed extremely well during the same time period, and the NCREIF farmland index delivered positive returns every quarter in which the S&P 500 declined.

Source: Nuveen

The benefits of diversification through alternative investments

Alternative investments include everything outside of traditional stocks, bonds and cash. Some classes of alternative investments, such as gold, real estate, or collectibles, will be more familiar to most investors. Other asset classes, such as US farmland, are less familiar but gaining in popularity.

Alternative investments have several attributes that make them attractive to investors, compared to the stock market. Many alternatives are less volatile than public markets, and their performance is uncorrelated with the performance of stocks and bonds. Alternatives can also deliver returns that meet or exceed the returns provided by the stock market — as shown in the earlier chart, farmland, private real estate and REITs all outperformed the average stock market return over a nearly thirty-year period. Finally, the right alternative investments deliver two forms of returns: price appreciation when the underlying asset is sold and periodic passive income.

Farmland: the newest oldest asset class

One alternative that is rapidly gaining in popularity is farmland. Until recently, farmland investing was out of reach for all but a handful of large institutional investors and ultra-high net worth individuals like Bill Gates due to a lack of transparency around the market and other high barriers to entry. However, new technology-enabled platforms like FarmTogether are changing the equation.

Farmland investing has many benefits that set it apart from investing in the stock market. Notably, farmland offers healthy returns — around 11.0% per annum between 1992 and 2020 — which come in the form of price appreciation and periodic rental and crop payments. Like gold, farmland offers a store of value in uncertain economic times and a hedge against inflation. Unlike gold, however, farmland is a low-volatility asset class that plays an essential role in the global economy. The value of farmland is further underpinned by its scarcity.