True Diversification

This is not investing advice. Seek a financial professional before making important financial decisions. This article is for informational purposes and should not be interpreted as a recommendation to buy/sell/or trade any security.



“Wide diversification is only required when investors do not understand what they are doing.” - Warren Buffett.


“Alternative investments should have positive expected returns and very low correlation to traditional assets” – Cliff Asness


--


There are very few rules when it comes to investing, but one is diversification. The need for diversification stems from the fact that human psychology and economies are so complex that the future is always uncertain. Therefore...no one should ever feel comfortable placing all their life savings in one basket. Do to so is gambling, no different than taking your life savings to a casino.

While even the most novice of investors recognize and abide by this fact there are a very wide range of views as to what diversification actually means. In this article we share our views on how we can improve upon the typical 60/40 stocks and bonds approach by exploring a wider and more complete set of risk dimensions.

Risk Dimensions

Risk dimensions include major sources of uncertainty that can drive the performance of assets. As we discussed previously...risk is not volatility. Risk is the potential for a permanent capital loss. And that can happen quite easily if you have too much exposure to any single risk dimension. We discuss three dimensions that apply specifically to financial assets...economic growth, inflation, and currencies.

Economic Growth and Inflation

Two of the most important risk dimensions are economic growth and inflation. The simplest map of investing environments is composed along these two dimensions. You can have periods of rising inflation (top right), rising growth (top left), falling growth (bottom left), and falling inflation (bottom right).



Oftentimes you can have periods of both meaningful growth and inflation. For example, right now we are in a period of falling growth and falling inflation (deflation). As the bottom two quadrants suggest...this has been a very good time to own bonds of all kinds, and to a lesser degree equities. What you don’t see in the bottom two quadrants are commodities such as oil, copper, gold and silver. With the exception of gold, commodities have done very poorly as deflationary pressures increased the purchasing power of the dollar and demand for commodities fell globally. This is typical in a recession.

Asset prices, however, adjust to reflect expectations for the future and there are good reasons to suspect that the future will be different from the past. We will recover from this recession, and when we do we will have a lot of government debt. Central banks globally are printing a lot of money to cover these debts and prevent corporate bankruptcies in order to keep unemployment from spiraling up into a global depression. As a result we at some point see economic growth pick up and with it inflationary pressures. This may result in order or both of the top two quadrants dominating the investing landscape.

We are not terribly optimistic about growth prospects in the near future. Bailouts tend to reduce the vigor of creative destruction that drives economic growth. Global debt levels are so high that businesses and households will probably be more hesitant to take risks and opt instead to increase savings. If that happens then we could move to an inflationary environment without much economic growth (top right)...and that would pose a problem for many investors. Another name for this quadrant is “Stagflation” (inflation without growth) … conditions we haven’t seen since the 1970s.

The 60/40 stock bond portfolio presumes that investors are “diversified” if they hold nominal bonds and stocks, but the top right quadrant suggests that neither of these assets will do well. That is why simply holding stocks and bonds is not a truly diversified portfolio.

This poses a critical problem for retail investors who often make the mistake of assuming the 60/40 portfolio provides substantial diversification. One reason for this is that even in a “normal” recession the gains from rising bond prices will generally not offset the fall in stock prices. Another reason is that today’s extraordinarily low interest rate environment leaves central banks without much from to stimulate the economy. So how does one gain exposure to the right kind of diversification?

The short answer is to gain exposure to financial assets that do well in an inflationary environment regardless of how fast the economy grows. These include inflation indexed bonds, precious metals and perhaps even commodities. Price matters of course. Gold has had a good run over the past year. Some commodities have already rebounded from very low levels like Silver and Copper. Falling interest rates have also sent the price of Treasury Inflation Protected Securities (TIPS) to record highs. We can’t know what the future will bring, but we do know that these assets tend to do better in the one scenario in which stocks and traditional bonds do not.

Currency Risks

Currencies provide another dimension of diversity often overlooked by retail investors. The US dollar has been the world’s reserve currency since the end of WWII. That’s a long time...longer than just about anyone can remember vividly. This seems to be why most everyone ignores it.


But you don’t have to look too far to find reasons to diversify currency exposures. The pound lost 12% of its value in dollar terms just two days after Brexit. At the same time the British stock market (FTSE) rose to a near record high near a record high when measured by the pound, but flat in US dollar terms. Meanwhile, folks living in the UK are starting to experience higher

inflation as the cost of imported goods has markedly increased. Exactly what the future holds for any given country is impossible to forecast, but Brexit provides a critical example for anyone who feels that 100% exposure to one currency, even if it’s their home currency, is a good idea.


Several factors suggest the almighty US dollar could become significantly less valuable over the coming years. One does not need to believe in conspiracy theories to support this view. Ignoring politics and concerns regarding the debt...we should expect that the steady growth of the world relative to the USA should put downward pressure on the dollar.


The US Dollar simply has further to fall than any currency in the world...and by a wide margin. The dollar represents 70% of global financial transactions and 65% of the global reserve currency basket. That made sense when the USA contributed to about half the world’s GDP right after WWII. But today the USA only represents 23% of global GDP and 4% of the world's population. While the US hopes to grow at a 2% real rate in coming years...countries like China and India which combined make up about a third of the world’s population are growing at over 6%. Emerging markets as a group already account for about half the world’s growth despite being a tiny fraction of global currencies and stock market valuations.


--


Diversification is the golden rule of investing...but to do it right you need true diversification. Entire institutions in the investing world have bought into the view that a 60/40 stock bond portfolio entirely concentrated in the USA is diversified. One may do well with this portfolio, but if they do it will be because certain possible scenarios never happen...especially a scenario of low growth combined with higher inflation, and/or a material decline in the dollar relative to foreign currencies.


We don’t know what the future will bring. We never claim to know anything with certainty. That’s why we hold a truly diversified portfolio.


--


Thank you for reading our article on True Diversification! If you enjoyed this then you may want to follow us on Twitter, Medium, or SeekingAlpha.


https://twitter.com/IntuitEcon

https://medium.com/@IntuitEcon

https://seekingalpha.com/author/intuitecon