Invest Wisdom

Hi guys,

For today and all of next week, I’m on vacation in Spain. I don’t think I’ll have access to a computer while I’m gone. Next week’s posting schedule won’t be every day as it normally is. Instead, you’ll get posts on Monday, Wednesday, and Friday. I hope you enjoy them and forgive me for not responding to questions or moderating comments before I get back on Monday, June 8.

Enjoy the week.

— Joe Light

A study from the Urban Institute came out a couple weeks ago analyzing how the stock market crash of 2007 and 2008 will hurt baby boomers’ retirement income.

They looked at three possible recovery scenarios: 1) No recovery - The market simply grows at its historical pace. 2) Full recovery - The market grows at a rapid pace and in 10 years hits the point that it would have had there not been a crash. and 3) Partial recovery - In 10 years, the market hits a point halfway between scenario 1 and 2.

You could argue that all three scenarios are optimistic. A lot of economists and experienced investors are saying that our growth rate going forward will actually be slower than the historic average. So the “No recovery” scenario might even be growing the market too fast.

But the study is good if for no other reason than to show that if you have more than a decade to retirement, you really don’t have to panic about this crash.

The study looked at three groups of baby boomers: pre-boomers (born between 1941 and 1945), middle boomers (1951 to 1955) and late boomers (1961 to 1965).

For late boomers, they found that retirement income for the average household would decrease 7.2% under the no recover scenario, but increase 3.2% under the full recovery scenario because of the crash. Remember that the “full recovery” scenario is a probably implausible rapid return to the pre-crash highs.

Pre-boomers lose money in all circumstances, shedding 8.5% of retirement income with no recover and 6.9% under a full recovery.

They also found that those high on the socioeconomic ladder were much more heavily affected because they tended to have more money invested. Middle boomers, for example, would lose 14% of their retirement income due to the crash under the no recovery scenario.

Anyway, the study slices the data many different ways. It’s decidedly optimistic, but for all you people under 30, seeing that even some boomers might actually come out ahead if optimism prevails has got to be heartening.

— Joe Light

In case you missed the news, most economists think the recession will end somewhere around the middle of this year. That doesn’t mean everything will go back immediately to how it was before the crash. They think growth will be slow, and unemployment won’t peak (at 10%) until next year.

I hope you haven’t kept your money out of the stock market until now, waiting for such a report. Because if they’re right, we’ve probably already experienced the market bottom and a huge percentage of the new bull market’s gains have already happened.

According to Ned Davis Research, market bottoms happen about 4 months before recessions end on average. Of course, history doesn’t have to repeat itself, but if economists are right and the recession will end in the year’s second half, that S&P 500 low in March (about 35% ago) was as low as the market is going to get.

Hopefully you haven’t been trying to time the market anyway and have kept your asset allocation pretty consistent throughout this whole mess. But if you need even more reasons to not wait around for someone to wave a green flag announcing the recession’s end, take a look at this list of press releases from the National Bureau of Economic Research. Scroll about halfway down the page.

Do you see what I’m seeing? It took the NBER between six months and two years to announce the official end dates of previous recessions and expansions. In fact, in November 2001, when the NBER announced that the recession had begun that previous March, the recession had actually already ended, though NBER wouldn’t make that determination until July 2003!

This is a short post, but it almost feels like too many words to explain one, easy lesson: Market timing is hard, if not impossible. The stock market tends to lead every leading indicator out there. So unless you want to make a fulltime job out of stock watching (and even professionals screw up all the time), you’re best off sticking to an allocation based on your own needs and goals rather than based on the news of the moment.

— Joe Light

Municipal bonds are often written about as if they’re as safe as Treasury bonds. As long as U.S. debt is denominated in dollars, the Treasury Department isn’t going to default on its debt (I mean, I suppose it could, but why?). On the other hand, the states and cities that issue municipal bonds can’t print money but they can tax the hell out of their constituents to pay debt off.

That’s led municipalities to have extremely low default rates. In fact, before the crisis hit its peak, single-A rated munis had a historical default rate of 0.0084%, which is 80 times lower than the historical default rate of AAA-rated corporate bonds.

California is one state facing serious budget difficulties.

Of course, that was before tax revenues fell through the floor. Now, states and cities want access to the same bailout money used to help banks. Congressmen have already written legislation to specifically help those cities that lost a lot of money making investments in Lehman Bros. debt. (Seriously? Cities were investing in Lehman Brothers?)

Of course, as an investor just looking to grow his money safely, you’re just wondering whether investing in your local muni bond is worth the risk of default. Here’s what I would consider.

What do you get for the risk?

The absolute safest investment you can make is one in a U.S. Treasury bond. So when considering a muni, the first and easiest thing to check is how much extra the muni will pay you for taking on additional risk.

Municipal bond rates will vary by municipality, but according to Bloomberg, the average, 5-year Treasury bond has a yield of 2.19%. The average 5-year muni bond’s yield is 1.82%. But because muni interest isn’t taxed by the Feds (and if you buy one from your own state, in most cases you avoid state taxes), the effective yield is 2.53%, assuming it would have been taxed at 28% otherwise.

Step one complete…for taking on the risk that a city or state defaults, you earn an extra 0.34% of yield for the average 5-year muni bond.

What is keeping a city or state from defaulting?

The main reason investors have long assumed states and cities won’t default is the one we’ve already addressed: The ability to tax. If a city had a $100 million bond payment coming up and didn’t have the money, it could simply raise $100 million in taxes by adding a temporary…I don’t know…marshmallow tax on anyone who wanted to make s’mores for the next 12 months.

Cities and states also don’t want to default because it seriously crimps their ability to raise capital later on. What investor wants to lend money to a city that recently defaulted? If a city did default, investors would demand much higher interest rates later on to make up for the risk, something that could hurt a city for decades.

Those reasons for not defaulting were pretty strong when cities and states faced their individual budget difficulties. But since the recession is making dozens of cities stare default in the face, the stigma of defaulting could disappear quick. (”Hey, everybody’s doing it!”) The question becomes: Are politicians more loathe to raise taxes in a recession or to shaft investors, many of whom their constituents are already angry at?

Warren Buffett recently said as much, though he was referring to muni bonds protected by insurance companies.

But finally, there’s this federal backstop that may or may not exist. Every state’s senators and representatives don’t want to see their hometowns go into bankruptcy. So they could offer up the seemingly unlimited coffers of the Federal Government to save them, and by extension, the poor saps who bought their muni bonds.

All of these reasons that things could be more or less dangerous are pretty hard to measure. And right now, the market seems to think that on the whole, the muni market is not nearly as dangerous as it was six months ago. Still, I don’t know if I’d run out and buy California general obligation bonds.

So what to do?

Although it’s not clear who, if anyone, is not going to make it out of this mess with their solvency, you don’t have to make a bet on any one government. There are plenty of mutual funds out there that will diversify you across muni bonds.

Take a look at this list of Fidelity muni bond funds for many states. I picked Fidelity at random. Any number of fund companies offer these.

If your state doesn’t give you a state tax break, you can also look at national muni bond funds (Since I’m already at their site, here’s Fidelity again.)

These options give you diversification across governments, which should cut down on some of your worries. No, it’s not a guarantee. Treasury bonds are still safer. But if you don’t have a ton of money to diversify with individual bonds, it’s better than staking a huge sum of money on one city’s fortunes.

— Joe Light

Last week, a Wall Street Journal columnist wondered if managed futures were really a healthy contribution to a diversified portfolio.

This week, absolute return mutual funds are under the microscope.

Absolute return funds are mutual funds in which the mutual fund manager can invest in or sell short nearly anything he wants. If he thinks U.S. stocks are primed for an upswing, he can buy U.S. stocks. If he thinks the Euro will surge against the U.S. dollar, he can invest in Euros.

That’s a big difference from the relatively tight boxes that normal mutual funds are stuck into. Most of the time, managers are limited to picking the best companies within, say, the U.S. mid-cap growth category. Because absolute return managers can bet against the market just as easily as they can bet with it, they’re supposed to make money whether the market is rising or falling.

Some mutual fund companies think that absolute return funds are the next big thing in their industry. I know of at least five that have launched over the last couple years and have spoken to a couple mutual fund managers who plan to launch them.

It’s a concept similar to one I discussed last month, and comes down to the same, fundamental question: Who should determine your asset allocation: You or an expert?

The Wall Street Journal columnist comes down somewhere in the middle, writing “The right absolute return fund can make a great addition to a balanced portfolio.” Despite that statement almost being a tautology (Just avoid the “wrong” absolute return funds, and you’ll be fine), I’m not sure I agree with the writer on what their role should be.

To me, “diversification” means diversification between assets. So even when one asset does poorly, another one can pick up the slack or at least do less poorly.

Investing in an absolute return fund, on the other hand, diversifies your investment styles. If you put 10% of your money in a total return fund and invest the rest yourself in your usual mix of index funds, your portfolio really now has two money managers setting your asset allocation: You, and the guy you gave 10% to.

There’s nothing inherent in the absolute return fund that should make it “zig” when others “zag” as the WSJ headline asserts. The manager could very well pick the exact same allocation that you had chosen. Instead, it seems like you’re completely at the mercy of how good the manager is at his job. Since so few of these funds have any sort of track record, I don’t think I’d be the first one to hop on the bandwagon.

— Joe Light

If you’re coming from the Carnival of Personal Finance at Greener Pastures, welcome! I hope you enjoy this post.

Invest Wisdom is all about helping ordinary people invest better. You’ll find that my take on many investment issues is quite different from your typical PF blog. Look in the right-hand sidebar to see some other things I’ve written recently. And please subscribe if you like what you see.

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Since starting this blog, I’ve paid more attention to other personal finance blogs around the web. Recently, I watched a back and forth about whether debt reduction requires laser-like focus or a more flexible approach. As I read the writers’ personal stories of empowerment and triumph, it occured to me how different most personal finance issues are from the process of investing.

You see, I don’t think of this as an empowerment blog. This stuff is about as far from motivational as you can get. But empowerment does have a place in most personal finance issues. A guy with $10,000 in revolving balances on his credit cards knows that he should spend less money (or earn more) to pay the debt down. He just needs a good kick in the pants or pat on the back to get the process started and keep him focused.

That’s why commenters like Suze Orman are so effective at what they do. They use motivators like “Why do you do this to yourself?” or “You’re better than this!” to either scare someone from a mistake or empower them to action.

But when I hear people using the same emotion-laden words to address economic or investment issues, I start to feel a little queasy. Today, Clark Howard, an author and personal finance radio host, published a piece about the rising dominance of China as an economic power. He noted our indebtedness to the superpower and compared fears that we’ll become subservient to them to the fears that Japan was going to take over in the 1980s. His conclusion: “But we will be fine because we have something they don’t have: We have freedom. And the power of that freedom is unbelievable. To do what you want, say what you want, live where you want.”

Call me crazy, but I don’t think freedom is going to repay trillions of dollars of debt to the Chinese or shift our economy from one that buys things from importers to one that makes things to sell to the rest of the world. (In context of the story, he doesn’t mean free markets—this is more your freedom of speech, I’m-proud-to-be-an-American kind of freedom.)

My favorite emotion for an investor or an economist is this: nothing. When I invest, I don’t want to feel good about a decision. I don’t want to be afraid of a decision, frustrated at a decision, and certainly not excited at a decision. I want to be about as dispassionate as I can possibly be and use only objective criteria in making the decision.

I’m convinced that this is why most people are lousy investors. We got emotionally excited about stocks and lost 41% last year. We became fearful of stocks and missed the recent 35% run up.

In short, the same inspirational talk that got you to take the major, positive steps to pay off debt, start 401(k) contributions, and open a Roth IRA will inspire you right into making poor investment decisions if you’re not careful.

This is why passive investing is the right choice for most people, even though it might not be the best choice that could be made if, like Data from Star Trek, we could just turn our emotion-chips off. (Sorry for the dorky Star Trek reference.) According to a recent study, investors lost 7 percentage points of annual return over the last 20 years by entering and leaving the market at inopportune times.

If you have trouble keeping your emotions in check, the best investing decision you’ll ever make will be to make as few decisions as possible. Set up automatic investments for your 401(k) and IRAs, set an allocation between stock and bond index funds once a year, and pay attention to your investments as little as possible. Yeah, I’m getting a little tired of writing and reading that same old advice. But it’s more prudent than “inspiring” you to make active investment decisions.

— Joe Light

Today brought the news that the “fear index” has fallen to its lowest level since Lehman Bros. went under. The CBOE Volatility Index (a.k.a. the VIX) technically measures the market’s expectation of nearterm market volatility. Basically, it measures how jittery investors are about rapid drops in market price.

Are investors no longer afraid of the market?

At its height, soon after Lehman’s bankruptcy, the VIX stood above 90. Now, it’s at about 28.75.

Some investors see this as a good sign that the worst is over. But for me, it recalls an old Warren Buffett maxim: “Be fearful when others are greedy, and be greedy when others are fearful.”

So now that stocks are up more than 35% from their low, investors are starting to feel much better. That would seem to suggest that the “deals” to be had in the market are rapidly disappearing. Still, at about 30, the index is well above the 10 to 20 range we saw in the five years before the crash.

A few people in a CNNMoney story on the subject seem to agree. Says a chief investment strategist quoted in the story: “A low VIX isn’t necessarily a positive. It could mean that people are getting comfortable and that might set us up to more shocks in the system. Investors might not be factoring bad news into the equation.” Several others quoted in the story said that they aren’t concerned as long as investors’ optimism continues to be backed up by good news.

I have enough trouble figuring out what’s going on in the heads of my friends and family members. So I’d never make a decision based on what I think all the minds of the market added together are feeling.

But if you’re a value investor looking for places to put your money, you’ve gotta wonder in the back of your mind if a drop in investors’ fear is really good or bad.

— Joe Light

Yesterday, I wrote a bit about choosing mutual funds. Today, I’m writing about deciding between mutual funds and ETFs and about funds of funds, including balanced funds and lifecycle funds.

The ETF vs. mutual fund debate

The Toronto Stock Exchange invented the first exchange-traded fund in the 1990s. But in the last few years, their popularity has grown rapidly.

In a mutual fund, a money manager collects a big pool of money from investors, which he then uses to go out and buy stocks or bonds. Every time a new investor enters the fund, the manager has new money to invest. Conversely, the manager might have to sell stocks when someone leaves.

On the other hand, an ETF starts with the securities, which are mixed together, split up, and sold to investors. Think of ETFs as a chicken pot pie. The money managers throw in stocks and bonds as its ingredients, bake it together, and slice it up into portions, each with a little bit of each ingredient mixed in. After they’re created, the ETFs are traded on an open exchange, just like a stock.

It might sound like they accomplish the same thing. For the most part, that’s true. But the structure of ETFs allows them to carry lower expense ratios than those of comparable mutual funds and operate with greater tax efficiency. For example, the Vanguard Total Stock Market ETF and Vanguard Total Stock Market Index fund are each designed to give broad exposure to U.S. stocks. The ETF has an expense ratio of 0.07%. But the mutual fund has an expense ratio of 0.16%.

As far as disadvantages go, since ETFs trade like a stock, brokerages charge investors the same commissions that they would if the investor had bought a share of, say, Intel. Over the last few years, commissions have come way down. So, that drawback has become less and less relevant.

Most ETFs have been created to passively track indexes (like the S&P 500) or sectors (like green energy). Managers found it hard to create actively-managed ETFs because regulations would require them to disclose their holdings much more regularly than they would in a mutual fund. Managers with big funds sometimes have to accumulate stocks over several days or weeks. Disclosing their holdings frequently would allow other investors to see what they were buying and front-run them.

Despite that setback, the first actively-managed ETF was released in 2007—ironically, by Bear Stearns just before it went under. Even more ironically, the fund’s ticker symbol is YYY (say it outloud). Since then, several other money managers have started or said they intend to start active ETFs.

In deciding whether to use ETFs or mutual funds for your own portfolio, your main concern is how your brokerage fees compare to your mutual fund’s expense ratio.

Because of ETFs’ brokerage fees, in general, mutual funds are better if you buy them regularly as part of a savings plan (such as if you’re dollar-cost averaging). ETFs are better if you’re investing a large lump sum at once.

Let’s look at a real-world example using the Vanguard Total Stock Market ETF and the Vanguard Total Stock Market Index fund.

In the first case, let’s say you have $10,000 to invest all at once. If you chose the mutual fund, you’d have no trading costs. Pick the ETF, and you’d pay your normal brokerage fee (let’s say $10). The mutual fund’s expense ratio is 0.09% higher than that of the ETF. So if you chose the mutual fund, you’d pay an extra $9 in fees (0.09% * $10,000) every year, which would move up and down with your account value.

The total cost of the ETF for the first year is slightly higher than the mutual fund, but in the second year, the mutual fund’s extra $9 or so quickly eclipses the ETF’s initial trading cost.

For the second case, let’s say you’re investing $10,000 over a period of 10 months. The expense ratio difference is the same, but the trading costs of the ETF ($10 * 10 trades = $100) is much higher. So it takes much longer for the ETF to catch up to the mutual fund’s fees.

That example had some flaws. Some brokerage fees are lower than $10; the $9 in fees could shift dramatically if the account value skyrocketed or plummeted; etc. But the general point is the same. The more times a year you invest, the less buying an ETF benefits you.

As a rule of thumb, if you’re investing more than $5,000 at once, an ETF beats an equivalent mutual fund, according to the editor of the Journal of Indexes. Of course, your particular case will depend on your brokerage fees and the expense ratio difference between the funds.

What about funds of funds, like balanced funds or lifecycle funds?

Balanced funds are funds that invest partly in bonds, stocks, and cash. They can achieve this through either investing in the securities directly or by creating an overarching fund that invests in some of the mutual fund company’s bond and stock funds. Balanced funds start with an allocation (say, 50% in bonds and 50% in stocks) and regularly rebalance to keep themselves at their target.

On the other hand, lifecycle funds or target-date retirement funds, which I’ve criticized in the past, set the allocation based on your intended retirement age, and change the allocation from risky assets to less volatile assets as you grow older.

While target retirement funds have their weaknesses, they’re better than not rebalancing at all or than investing completely in stocks or bonds. Vanguard’s target retirement fund for those retiring in 2010 fell 21% last year—a terrible hit for someone nearing retirement. But if that person had just invested 100% in stock funds, he would have lost more than 40%.

If you use balanced funds, make sure you understand how they impact your overall allocation. Target retirement funds, for example, are intended to be the only mutual fund you hold. If you invest in stock or bond funds on top of the target fund, you’ll throw off the allocation that the money manager thinks is appropriate for someone your age. You may decide on your own that you want to be more conservative or aggressive than that manager. But at least pay attention to the underlying allocations of each of your funds.

When choosing a fund of funds, make sure you pay attention to the fund’s overall expense ratio. Fund of funds’ expenses are based on the expenses of each underlying mutual fund with a small overall fee thrown on top. Some websites only report the overall fee. So make sure you look at a fund’s prospectus to determine its total fee.

If you’re picking a fund whose allocation changes based on your age, you should also look at the prospectus or at a website such as Morningstar.com to see how the fund is split between stocks and bonds. Different mutual fund companies sometimes have drastically different ideas about what allocation is appropriate for people the same age. So you should figure out who you agree with. If you like a fund company but they seem too aggressive for your tastes, you could pick, say, the target retirement 2015 fund even though you’re retiring in 2025.

Again, these funds have their drawbacks, but if you truly want to “set it and forget it”, they’re an inexpensive choice.

— Joe Light

I write a lot in this blog about analyzing companies and company stocks. But the fact of the matter is that most investors, especially those who have better things to do than troll through a balance sheet, should devote most or all of their investments to mutual funds. If you have only a little time to devote to investing or if you have little money to invest, mutual funds can provide you plenty of diversification at a good price.

But unfortunately, picking a mutual fund isn’t as easy as you might think. According to the Investment Company Institute, there were 8,029 mutual funds in the U.S. in 2007, and 66,350 worldwide, not including most funds of funds (such as lifecycle and target-date retirement funds). To put that in perspective, the Fidelity Spartan Total Market Index fund, which is supposed to track the performance of the broad U.S. stock market, only holds 3,193 stocks.

For most investors, the great majority of mutual funds and ETFs are unnecessarily complicated or expensive. Despite that, building a portfolio of mutual funds isn’t hard.

Over the next two days, I’m going to go through the process of choosing mutual funds, whether it be for an IRA, Roth IRA, 401(k), or taxable account. This is going to assume that you’ve already determined what your asset allocation should be. If you haven’t, check out the calculator here for a quick rundown. It’s pretty simplistic, but it’ll give you a place to start.

Today, I’ll discuss the reasons passive, index funds are better choices than actively-managed funds most of the time, and what you should pay attention to with mutual fund fees.

Tomorrow, I’ll address the mutual fund vs. ETF debate and the benefits and drawbacks of funds of funds (including balanced funds).

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If I had to break down my requirements for a mutual fund into as few words as possible, it’d go like this:

Index funds, low fees, no loads.

Simply follow that, and it will be hard to go wrong.

But if you want to see some of the reasoning behind that advice or get into more detail, read on.

* Pick funds with low expenses.

Though there are thousands of funds out there, you’ll dramatically cut down on your choices simply by picking funds with below average fees. As you scan the list of available funds in your 401(k) or use a screener like the one at Morningstar, eliminate any that have expense ratios above 1.5% and red flag any others with expenses above 1%.

According to ICI, the average stock mutual fund in 2008 had an expense ratio of 0.99%. The average bond fund came in lower at 0.75%. Paying above (or even at) those averages just doesn’t make sense in nearly any circumstance when there are so many that can beat those fees.

The great majority of investors should also never pay a front-end or back-end load on a mutual fund. These are common in funds sold by commission-based financial advisers. With a load fund, you have to pay a commission (sometimes up to 5% of your total investment) upfront when you invest, or alternately you have to pay the percentage when you withdraw. Even funds with a share class that charges a load most often have share classes with no load. There are few reasons to pick a load fund. So, don’t.

You should also focus on funds with as little turnover as possible. Turnover is a percentage that measures how many of the holdings inside the mutual fund are changed within the year. Mutual funds that trade often spend a lot on brokerage fees and taxes. Very large mutual funds, which have to buy millions of dollars worth of stock at once, also pay a hidden cost, as their large purchases drive up the price of the stock they’re trying to accumulate.

* Think twice before choosing an actively-managed fund over an index fund.

It’s been well documented that active fund managers—that is, managers who try to pick stocks to outperform the market—underperform the index over time. Last year, the S&P 500 outperformed 72% of large-cap mutual funds.

While mutual funds’ records have been better in past years, picking a winning active fund manager is still a crap shoot. Even those who perform well one year, often underperform in subsequent years, erasing any advantage you had. In addition, active mutual fund managers charge you more than index funds for their expertise. So even if an active fund manager mirrored the index, the passive fund would make you more money, because it charged lower fees.

It’s not clear why actively-managed funds aren’t able to do better than average. Some people point out that since so much of the stock market is controlled by money managers, when you combine their returns, you’d just about have to get an average. When you have a stock market as closely monitored as that of the U.S., it’s also harder to find bargains that others haven’t already found (or so the argument goes). But in the end, the reason doesn’t really matter. The proof’s in the pudding. (Side note: For an explanation as to why I’m not using “proof in the pudding” correctly, see here.)

If you have choices between funds that track the same index, simply pick the no-load fund with the lowest fees. Those run by Vanguard and Fidelity are good, low-fee options. Some of Charles Schwab’s index funds also recently became the low-fee index fund leaders.

So, after all that, you still want to take a look at actively-managed funds? If you insist, take a look at Morningstar.com, enter the potential fund’s ticker symbol, and take a look at the fund’s track record over the last five years. Pay particular attention to the second row, where Morningstar compares the fund’s returns to that of the comparable index. You want a manager who has consistently beaten the index by a substantial margin.

If you’re using the active fund to fill out part of your overall asset allocation, scroll down the “Snapshot” page to see the “Asset Allocation %” of the fund. There you can see how true to the fund’s name the manager stays. The FPA Capital fund, for example, is a stock fund, but right now, its managers have 31% of the fund’s money in cash. That doesn’t mean the manager’s messing up. But it does mean that if you used only that fund to make up the “stock” portion of your allocation, you’d really have nearly a third of your stock money in cash.

It’s a bit of homework, but it’ll pay off if you want to choose an active manager. Even after doing all that work, I’d still devote only a portion of your portfolio (10% or less) to active funds and put the rest in low-cost index funds. You won’t regret it.

Come back tomorrow to read a little bit about the mutual fund vs. ETF debate and funds of funds.

— Joe Light

To those arriving from the Carnival of Personal Finance at Wisebread, welcome! I’m glad to have you here. Invest Wisdom is a blog designed to help you invest better, whether it be for retirement or some other goal. You can check out posts I’ve recently written at right. Or if you like what you see, please subscribe. You won’t regret it.

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There’s a saying on Wall Street that the only thing that goes up in a market crash is correlation. In lay terms, it means that “non-correlated” assets—that is, assets that are supposed to move in opposite directions to reduce a portfolio’s volatility—might suddenly move down together in extreme circumstances.

Not many asset classes were left standing last year.

That was certainly the case during this market crash. Nearly every asset class, whether it was bonds, stocks, real estate, or commodities, lost value. Many people have interpreted those results to mean that diversification doesn’t work.

One or two asset classes (I debated whether or not I should have put “asset class” in quotes) did make money. And you better believe those who manage them are letting people know about it. Managed futures are one example. Managed futures are run by commodity trading advisers who buy and short futures contracts for all sorts of asset classes, like commodities, stock indexes, and currencies.

Their returns for the last several years have been ridiculously good. On average, they beat the stock market by 51% last year, according to one index. I’m not too familiar with managed futures, but a columnist with the Wall Street Journal does a good job explaining why it might not be a good idea to jump into them based on their recent performance.

I would extend that warning to anyone looking for new asset classes to add to his portfolio and prevent drops like we saw last year. For one, it’s never a good idea to invest in something you’re not familiar with. Second, the factors that helped the new asset offset the losers might not be there next time, as the Journal columnist argues. But finally, ask yourself if diversification truly “didn’t work” last year.

Yes, corporate bonds lost money along with stocks, but they didn’t lose nearly as much. In fact, if you had simply invested in a total bond market fund (of which nearly a quarter would have been Treasury bonds) your fund would have made a few percentage points.

My feeling is that in times like last year, you’re likely to lose a substantial amount of money no matter how many asset classes you spread your investments in. If you want to earn a return above what cash equivalent investments give you, you’ll always have to take on risk. A new asset isn’t going to fix that.

— Joe Light