It is said that diversification is the only free lunch in regards to investments. While that may very well be the case, done the traditional way it is one of many ways to not be able to pay for your next lunch.
If you go to most financial planners or stockbrokers they will tell you things like be 60% in stocks and 40% in bonds. Or maybe X% in Large Caps, X% in Small Caps, X% in Treasuries, and X% in Corporate. Sounds great right? Along with this “diversified portfolio” you get the whole pitch that some of these will zig while the others zag so being in these separate asset classes smoothes out your returns so that you never have a drastic loss.
Do you see a problem with any of this so far? The problem is not that diversification can be a wonderful tool. The problem is that just because you are in a bunch of different funds you aren’t necessarily diversified. Take the above example: two classes of stocks and two classes of bonds. If you actually look at what drives those asset classes you will find that over time you don’t really have four positions you have two. Interest rates drive bond returns for the most part regardless of if they are corporates or treasuries. What drives stocks? Interest rates and corporate earnings.
I already hear some of you saying “well in the last crash Large Caps went down while Small Caps went up.” Yes, this time that is what happened but over the long haul this doesn’t hold up. In fact since 1995 the returns between the SP500 and SP600 had an 80% correlation. And while the SP600 has definitely outperformed guess when it got hardest hit……..yep 1998, 2002, and summer of 2006 the same times as the SP500. So when you needed it most the diversification fell apart.
So how do you properly diversify? Invest in multiple strategies in multiple asset classes. For instance instead of just domestic stocks and bonds you could add commodities (energy, metals, agriculture, etc.), global stocks (both developed and emerging markets), global bonds (again developed and emerging markets), and real estate (same thing developed and emerging markets), hedge funds, private equity, venture capital, currency trading, and possibly even collectibles like art. Obviously some of these have minimum net-worth requirements but the point is to invest in as many disparate and risky asset classes that you can.
Why diversify so much? Because that is the only way to achieve true diversification in a portfolio. Stocks zig a little differently from bonds which zag differently from commodities which zig differently from global stocks etc.
Obviously this is not all there is to it but it is a lot better then the traditional 60/40 stock bond mix. In Part Two we will discuss how to decide what types of strategies to look for. And in Part Three we will discuss different ways to decide how to weight your investments in each asset class.
The Macro Trader