Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?
Stock diversification is overrated.
Alternatives are more overrated.
High quality bonds are underrated.
This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best. First, I don’t like infographics or video. I want to learn things quickly. Give me well-written text to read. A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.
Here’s the problem. Do you want to reduce the volatility of your asset portfolio? I have the solution for you. Buy bonds and hold some cash.
And some say to me, “Wait, I want my money to work hard. Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?” In a word the answer is “no,” though some will tell you otherwise.
Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. Those buying stocks stuck to well-financed “blue chip” companies.
Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:
And initially, it worked. There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.
Now, was there no diversification left? Not much. The diversification from investor behavior is largely gone (the liability side of correlation). Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them. How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?
