Combining multiple asset classes into one portfolio provides a more robust approach to inflation protection than a single-asset portfolio such as equities. To illustrate, we create a Four Asset Portfolio comprising equal weights of REITs, commodities, stocks, and bonds.³ In Figure 1, we show the rolling five-year returns of this Four Asset Portfolio versus the S&P 500. The five-year window was used given its closeness to the average business cycle and its prevalence as a "long-term" benchmark for institutional portfolios. Given that we are looking for inflation protection, we also show the five-year rolling average of inflation plus 5%-a standard objective for endowments, pensions, and 401(k) advisers.

Figure 1. Four Asset Portfolio vs. S&P 500, 1972-2007

We find that both the Four Asset Portfolio and the S&P 500 achieve inflation plus 5% in most periods. In fact, the Four Asset Portfolio beats this bogey in 73% of the rolling five-year windows, whereas the S&P 500 achieves this bogey 67% of the time. But while the frequency of achieving the CPI + 5% bogey is similar, the magnitude of shortfalls is not. When the S&P 500 falls short, it really falls short-trailing on average by 6.8% including several instances where equities trailed CPI + 5% by over 1,000 basis points! The power of negative compounding makes these equity shortfalls particularly damaging to real wealth creation. Meanwhile, the Four Asset Portfolio incurs a much milder deficit of 3% when it fails to meet CPI + 5% over five-year periods. Indeed, the worst shortfall over the entire 35-year period was 6.8%, virtually matching the average shortfall for the S&P 500.

Of course, equities can produce huge premiums to CPI + 5% during the good times, well above that of a more diversified inflation-protected portfolio like our simple Four Asset mix. Seemingly, these massive stock market runs would propel the S&P 500 to a greater cumulative return over the entire 35 years. But it doesn't, as Table 1 shows. The Four Asset Portfolio and the S&P 500 finish in a virtual dead heat, compounding at an impressive 11.2% over three and a half decades.

The real story relates to the risk reduction achievable through a multi-asset portfolio. In the case of the simple Four Asset Portfolio, annual volatility is 45% less using the combination of REITs, commodities, bonds, and stocks versus stocks alone.

Stocks may still be the best way for investors to achieve growth and inflation protection over the very long term. This discussion clearly illustrates, however, that these goals can also be met with greater consistency and less risk, particularly over more measurable intermediate horizons by combining multiple assets, each with its own unique real return driver.

¹Stocks for the Long Run by Jeremy J. Siegel, 2008, New York: McGraw-Hill.

² For a fuller discussion on commodity futures return drivers, see "The Nature of Commodity Index Returns" by Robert Greer, The Journal of Alternative Investments, Summer (2000): 46-47.

³ Four Asset Portfolio consists of 25% S&P 500, 25% 10-Year Bond Total Return, 25% S&P GSCI Commodity Index, and 25% FTSE NAREIT Index.

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© Research Affiliates^®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

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