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It’s time to look beyond the standard two pillars and consider third-pillar assets that offer both inflation protection as well as the potential for reasonable returns.

Ridofranz/Getty Images/iStockphoto

In a world where mainstream investments have grown too expensive for comfort, people who stick to conventional portfolios are doomed to disappointment.

That's the intriguing argument put forward by Rob Arnott, the chairman of Research Affiliates LLC, an investment research firm in Newport Beach, Calif. He says that investors can't count on the standard, plain-vanilla portfolio mix of 60 per cent North American stocks and 40 per cent bonds to provide anywhere near the same lush returns as it has in the past.

"The classic 60/40 portfolio was a wonderful answer in the past," he says. "It's a terrible answer for the future."

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He thinks investors should be devoting more of their money to areas such as emerging market stocks, inflation-protected bonds and commodities. "What makes it challenging is that many of these assets have been disasters over the past 30 months in terms of relative performance," he says. "But that's precisely why they're priced now to offer superior future returns."

Mr. Arnott's opinion matters because he's a rare creature – a well respected iconoclast. He's best known for inventing a new approach to index investing based on fundamental factors such as dividends and cash flow. He also manages an all-asset strategy for bond giant Pimco and has a shelf full of professional awards he has won for his research, which has challenged conventional thinking in areas ranging from retirement planning to dividend investing.

His case against the time-honoured 60/40 strategy is based on the notion that it's nearly impossible for the future to repeat the past.

Over the past 30 years, a conventional 60/40 portfolio has pumped out close to a 10 per cent annual return for North American investors. What many people don't realize, however, is that those returns have been driven by the willingness of investors to pay ever-expanding amounts for a dollar of income. That process is reaching its mathematical limit.

The dividend yield on U.S. stocks has slid from 5 per cent a generation ago to a stingy 1.8 per cent now. Meanwhile, the yield on safe bonds has plummeted from the double digits to barely 2.5 per cent. Those paltry paybacks can't slide much further without hitting zero.

"Mainstream stocks and mainstream bonds, the two pillars of most portfolios, are both priced to produce pretty lousy returns," Mr. Arnott says.

The two traditional pillars are also more vulnerable to inflation than many people realize. "Both mainstream stocks and bonds are essentially short positions on inflation – they do better when inflation is falling, worse when it's rising," he says. If inflation does reignite at some point – and Mr. Arnott thinks there's a strong chance it will – both of those assets will be hard hit.

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For those reasons, he says it's time to look beyond the standard two pillars and consider what he calls third-pillar assets that offer both inflation protection as well as the potential for reasonable returns. He sees six investments that fit this description: inflation-protected bonds, high-yield bonds, commodities, real estate investment trusts, emerging market stocks and emerging market bonds denominated in local currencies.

Of course, several of these assets also have more thrill factor than conservative investors might desire. Chinese stocks, for instance, have produced particularly stomach-churning swings in value over the past few weeks.

However, third-pillar investing doesn't necessarily have to be a white-knuckle ride. "Individually, these markets are volatile," Mr. Arnott says. "Collectively, they're far less so." In fact, an equal blend of all six third-pillar asset classes has historically been no more volatile than a standard 60/40 portfolio.

If you find Mr. Arnott's perspective to be persuasive, he suggests allotting a reasonable portion of your portfolio to these non-mainstream investments. Instead of the standard 60/40 blend of two asset classes, you might consider splitting your portfolio three ways: one third to mainstream stocks, one third to mainstream bonds, and one third to a mix of third-pillar assets.

To be sure, investing this way does require a leap of faith. The strong returns in recent decades from a classic 60/40 investing blend have largely vanquished intellectual opposition and made that asset allocation the default choice for financial planners.

But Mr. Arnott argues the high degree of consensus around the 60/40 strategy is also what makes its future far less bright than its past. Assets that perform well for extended periods inevitably get bid up to valuations that ensure disappointing future returns. "It's an obvious truism," he says, "but one that people always forget."

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