Investment Strategies Part 5: In Defense of Diversification

The following is a guest post from Marotta Wealth Management.

Diversifying your asset allocation among investments with a low correlation can and should reduce your portfolio's volatility and boost your returns. But critics are claiming this strategy is no longer valid. That's because they don't understand the nature of what happened in 2008.

Fickle followers of asset allocation point to the market drop in the fourth quarter of 2008 as evidence that diversification has been discredited. Every investment philosophy and asset class moved downward at the same time. They point out that asset classes are more highly correlated when stocks move down than when they move up. In other words, they complain that just when diversification was supposed to help, it failed.

So does modern portfolio theory need to go back to the drawing board? In many cases critics are not suggesting alternatives, but they are sure something else is needed. They see the trees but are missing the forest.

Correlation is measured mathematically and does not necessarily reflect a causal explanation. It is a fact that every investment class moved down at the same time. But you must understand why in order to evaluate ways to defend against it in the future.

Everything went down in sync because it is all denominated in dollars. The markets moved not because the markets changed but because the value of the dollar changed.

When all the financial institutions either had to deleverage or go bankrupt, they needed dollars for their very existence. The demand for dollars naturally went up. When the credit markets froze and financial institutions would not lend to each other because they suspected their collateral was toxic, the velocity of money went to zero. As a result the demand for dollars went up.

When the value of the dollar doubles, everything else denominated in dollars drops in half. Deflation sinks all ships equally. Everything consequently moves in sync, and correlations approach 1.0.

For example, take investments A and B. Imagine that A would have gone up 2% while B would have gone down 2%. These two investments would have had a correlation of −1.0. They would have been perfectly negatively correlated and provided diversification. But when the demand for dollars skyrockets and both investments are denominated in dollars, the result is very different.

In that case, investment A goes down 48% and investment B goes down 52%. The movement of the dollar swamps the relative movement of the underlying asset, and all correlations approach 1.0.

In my December 2008 article, "When Will the Markets Stop Dropping?" I wrote, "It is as though your next-door neighbor got into credit card debt and is now trying to pay it off. On his front lawn he is having a yard sale. His couch is going for $10, his good china for $20 and his plasma TV for $25. And you think to yourself, "That's the exact same couch I just paid $200 for, and my neighbor is selling it for $10!" In fact, you are amazed that the entire contents of your house have dropped in value.

"Diversification among household contents did not help because the financial institutions that are deleveraging also owned a nice diversified portfolio. Nothing is fundamentally wrong with couches, china and plasma TVs. The problem is that when a nation is deleveraging, everyone wants cash to pay off their debts."

No one wanted shares of stock because they needed cash to deleverage and survive. Financial companies wanted barrels of oil even less as oil dropped from $140 to $32 a barrel. The downward slide in oil and other commodities provides further evidence that the movement was a movement in the value of the dollar.

In other words, if you measure the market's return in dollars, it dropped roughly in half. But if you measure the market's return in barrels of oil, it doubled in value.

You can see additional evidence as the federal government began pouring trillions of dollars of bailout money first into the financial institutions and then salted liberally through government largess. The primary purpose was to devalue the dollar and therefore revalue stock prices. They wanted to stop deflation and reinflate stock market values.

So, assuming my analysis is correct, how could investor portfolios that are valued in dollars have been protected against a sudden and sharp demand for dollars? Well, the short answer is that with a few exceptions, they couldn't. It wasn't just a failure of diversification. Most other strategies failed worse. So-called balanced funds or target funds have seen a decade of losses. Because they have fewer equities, they didn't have enough growth in the decade before 2008 to remain positive. Only the diversification into small value, foreign, emerging markets and hard assets gave well-diversified portfolios a positive 10-year return. And ironically, the categories with the best 10-year returns are the same ones that dropped the most at the end of 2008.

We could liken searching for a viable strategy when the dollar suddenly doubles in value to looking for a safe location when the sun goes supernova. But in our case, what would have been trying to be safe in 2008 would only be extremely foolish in 2009. What is safe when the dollar suddenly doubles in value is extremely foolish when the government is relentlessly pouring out dollars to devalue it.

A recent Wall Street Journal article quoted Ibbotson Associates chief economist Michele Gambera about what he deemed safe in the event of such a nova. Gambera concluded that only a few asset classes other than cash proved helpful. They were gold, intermediate-term government bonds and Treasury Inflation-Protected Securities (TIPS). Well, there are few surprises in that list. Cash and cash equivalents are always a good investment when the demand for cash suddenly increases.

But sometimes cash and fixed-income investments are as equally risky as they were prudent this past fall. Now that the dollar is being devalued, cash is a risky investment. We recommend that at least half of your portfolio be protected against the risk of a falling dollar. You can do so with investments in foreign bonds, foreign stocks and hard asset stocks. One of the best ways to protect your portfolio, hard asset stocks as a class have also provided one of the best returns since 2002.

Gold is a strange category for Gambera to include in his recommendations. Investments in gold did not fare well in the last half of 2008. Gold prices topped $1,000 an ounce in the summer of 2008 and dropped to a low of about $700 at the bottom of the markets in November. It is true that during times of market turmoil many investors flee to gold and push the demand for gold higher. In the recent situation, however, crisis gold did not correct as much as the markets and has still not rebounded well. Although on average, gold doesn't appreciate more than inflation, it is still normally a safe store of value. Just not in the fall of 2008.

So how much of your investments should you allocate to cash, treasuries and other stable investments? Always keep five to seven years of spending in relatively stable investments. That will help you sleep well during a dollar crisis--at least for the next five to seven years! The remainder of your portfolio should be able to weather the duration of even this tsunami.

So is asset allocation dead? By no means. No better way exists to protect your investments. But all these events remind us that monetary policy, deficit spending and the actions of the Federal Reserve do impact currency stability.

The markets are inherently volatile, including the financial markets that trade loans. It was government intervention in the credit markets that helped put all our eggs in one basket. The Community Reinvestment Act (CRA) and government-run Fannie Mae and Freddie Mac contributed to the lending crisis. Their policies encouraged or even required financial institutions to make loans to those with little ability to repay. The unintended consequence was the shock of the imminent failure of our financial system and the sudden dive in the value of the dollar.

Recently, monetary policy is moving in the other direction. The markets are going up partly because massive government deficit spending is devaluating the dollar. Now is not the time to protect your assets against deflation. That tsunami has passed. The current danger is a backwash flowing in the opposite direction. Now is the time to protect your assets against inflation, and cash again may be the most dangerous asset category.

Comments

[Apex]

I hate to be cynical but I can't help it.

A money manager now says that in hind sight cash was a great asset last year but a very dangerous one going forward?

Somehow money managers never seems to think cash is a good investment for the future.

And it's always the same cry, you can't be in cash, inflation is gonna kill you. Said in every year I have been alive. Except inflation doesn't kill you (not slow inflation anyway - no one said you have to be in cash for the next 20 years). What kills you is losing 50% of you assets in a year, but thats only affecting about 90% of people who made sure not to get killed by cash so no big deal.

Cash now has better returns than the market for about the last 15 years running. I don't expect that to continue forever certainly but the idea that cash is stupid is very forcefully promoted by those who make no money if you just stick all your assets in cash. Banks never tell you cash is stupid (unless they have an investment arm, then they might), only people who make money when you ask them what to do with your money. If they tell you to just put it in the bank, how much you think you are willing to pay them for that advice.

The money management industry always has the same message, namely, regardless of what yesterday has held, tomorrow always holds the same thing and that is "Cash will kill you."

What ever happened to Cash is King Baby!

[Eugene Krabs]

Well, actually, I'm thinking basically the same here. When we hit a momentary deflation, I was into cash like crazy.

And while I do not believe in attempting to forecast the future, there is nevertheless a strong possibility of inflation.

But that's if you're attempting to actively manage your portfolio. But even for passive investors, some have always argued that there should always be a small hedge in there against inflation. VIPSX is often recommended for such a hedge.

Regardless of the credibility of the author in the eyes of the crowd, I think this entry is basically spot on. What people need to understand is that:

1. This recession is an extraordinary event. It isn't normal at all. As such, it also breaks all kinds of conventions and usual rules that the market would normally follow.

2. In today's global marketplace, the correlation among equities may be higher than once imagined. Therefore, especially for conservative and passive investors, I think it is OK to lean towards less equities in general, and more towards other asset classes. For that matter, I would argue that internationals shouldn't be increased even thought that seems to be in vogue at this time.

Just my opinion anyway.

[Eugene Krabs]

Just wanted to elaborate what I meant by "into cash like crazy". It meant I was buying with cash, not hoarding cash. Cash was strong due to deflation, and I bought what I felt were under-valued investments. With inflation looming, it's best to have some kind of hedge against inflation, but once it does hit, then I will be stockpiling cash pending upside.

[Tyler]

First, modern portfolio theory assumes risk and volatility are the same. Thus, it's intention is to reduce volatility at desired portfolio returns along the efficiency frontier. (if I want x returns I will get x risk/volatility) Diversification allows one to reduce volatility at desired return when compared to a non diversified portfolio at the same returns. It does not try to reduce absolute losses of principle.

Love this logic "It wasn't just a failure of diversification. Most other strategies failed worse." Failure is failure. If you lose money, you lose money. If you fail, you fail. Doesn't matter if you lost less or failed less.

"Everything went down in sync because it is all denominated in dollars. The markets moved not because the markets changed but because the value of the dollar changed." This is wrong on so many levels. The market did change. The risk profile did change. Non dollar assets also went down. Corrs went to 1 because when you need capital you sell whatever you can, which drives down the price of lagging asset classes. Has little to do with the dollar.

"Always keep five to seven years of spending in relatively stable investments." Irrelevant advice for 95% of the population.

Historically, gold is a hedge against inflation not deflation.

Bold statement to claim deflation is over. Shouldn't a diverse portfolio consider both the risks of future inflation, deflation and stagflation?

This post is just bad- sorry.

[Apex]

@Tyler,

Obviously I agree and you make some good specific points as well.

I too found the dollar argument to be extremely misguided. If the dollar was the primary cause of the losses then one would expect that assets denominated in other currencies that moved up against the dollar should have performed amazingly well. The Euro moved up considerably against the dollar but Europe got crushed in tandem with the U.S.