Can diversification save you today?

What goes up when everything goes down...?

"INVEST for the long-term...Diversify...We are in a period of Great Moderation in volatility, so don’t panic...”

   The short version of this story is that you should probably ignore all the soothing platitudes about investing for the long-term. No one has ever proven that an entire generation can retire by treating the stock market like a savings account. With no evidence that it’s ever been true, we have no reason to believe this time will be any different.

   It’s a big gamble to take with a life time’s worth of capital at stake. But it might be fun to watch!

   Our suggestion is to panic now and avoid the rush later. Soothing axioms barely disguise the truth that markets today are more volatile, not less, and that what you saw last week is taste of what you’ll have to get used to from now on.

   Depending on the good will of “the market” to see you through to retirement is like depending on the good will of a cannibal to not to eat you once he’s got you in a boiling pot. A cannibal can’t help what he is. And the market can’t help doing what it does best, separating a fool from his money.

   There are millions of fools out there, although some are bigger than others.

   “An investor’s two best friends,” writes American financial guru Ben Stein, “are time and diversification. Get the broadest possible market indexes. Spread yourself out over large and small caps. Have a large dollop of the developed foreign and a goodly chunk of the developing market. Yes, it’ll be a rocky ride in China and Brazil, but over long periods you’ll do great."

   Exactly what portion of your portfolio is a dollop? How do you tell a goodly chunk from a badly chunk? And over the long-term, aren’t we all dead?

   We don’t mean to be petty or quibble. But man, if anyone walks into the Old Hat Factory and starts mentioning the word diversification as a bear-market survival strategy, he had better duck. There will be coke bottles and curse words flying, unless he can explain himself, and quickly.

   Here’s our beef with the word "diversify" – the idea of diversification is based on the existence of negative correlations between sectors or asset classes. When X zigs, Y tends to zag. And diversification makes sense if some things go up while others go down. And it used to be that some things went up while others went down.

   Bonds went down in inflation, commodities up. Cash is more valuable when the money supply shrinks. Shares and property don’t always move in tandem. Emerging markets move up faster in bull markets than blue chips, but fall faster in bear markets.

   Pre-Greenspan, there were certain inter-marker relationships that made sense and that you could prove with real performance data. There were, for example higher yields on foreign markets and emerging market bonds than on US savings bonds. Perhaps it sounds naïve today, but those higher returns – those risk premia – were the reward you got for taking a bigger risk with your capital.

   If you wanted a safe savings account, you weren’t going to make much money in it, maybe a few percent above inflation. But if you were willing to buy Brazilian stocks or Icelandic bonds, well that was another matter entirely. You might be crazy. But you might also be right. And you deserve an few hundred extra basis points for being crazy, brave, and correct.

   But for the last four years, risk premia have nearly vanished. These days, everyone is crazy, no one is brave, and many people are wrong. We say no one is brave because bravery requires some knowledge or appreciation of the nature of the risk you’re taking.

   Yet no one seems to think investing in shares is all that dangerous.

   “Corporate balance sheets are in good shape. There’s been a sustained decline in macro-economic volatility over the past decade, thanks to structural changes that have improved the ability of economies to absorb shocks and better monetary policy. It is," as then-Federal Reserve Governor Ben Bernanke said in 2004, the era of “the Great Moderation."

   "Such an extended period of calm probably explains investor’ bold, risk-happy behaviour,” writes Corinne Lim in today’s Australian Financial Review. Such an extended period of calm usually precedes all hell breaking loose.

   Stability breeds instability, as economist Hyman Minsky famously pointed out. There has been a ton of breeding going on in the last few years. We saw the first birth-pangs of instability last week. But not the last.

   All of this happens for a simple reason, there is too much money chasing too few assets. This doesn’t mean the risk has vanished from certain types of assets. It just means you no longer get compensated for taking it, which seems like a bad bet to us. And with money charging around the globe buying up things willy nilly, the art and science of valuation itself appears to be temporarily worthless.

   Can diversification save you? What does that word even mean in a world flooded with liquidity and cheap money? How is it possible to truly diversify in a market where there’s so much money chasing so few stocks that everything is going up regardless of traditional methods of valuation?

   If diversification is based on the observation that some asset classes are inversely correlated (that X goes up when Y goes down etc), what happens in a liquidity-driven market...say one where super contributions are increasing while the supply of assets is not?

   When all asset classes start moving up because of excess liquidity, there is no longer any negative correlation. X and Y move up along with A, B, C, D, E, and F. And they all move down at the same time too. Right?

   How then is it possible to structure a portfolio in the modern world where you are compensated for the decline in one asset or sector with the rise in another? With everything rising in lock-step over the last few years, isn’t the risk now that everything will fall in lock-step too?

   No! We read that real diversification is possible, but at a price, in an article called “Special strategies come at a high price,” by Jonathan Barrett in today’s Fin Rev. To achieve it, you must expect to pay a 2 per cent fee, an adviser trailing commission of 0.3 per cent, and an annual management fee of 1.85 per cent.

   And for that pretty penny you will buy a fund which, “has the potential to generate positive returns in market conditions that are adverse to traditional asset classes, thereby providing diversification benefits within higher risk traditional growth portfolios," says firm researcher Lonsec.

   Also featured in the article were steps on how to eat chocolate without getting fat, cheat on your taxes without getting caught, and make more money by doing less work and drinking only single-malt scotch for breakfast and lunch, red wine for dinner.

   Does anyone really believe this anymore, that you can generate positive returns in market conditions that are “adverse to traditional asset classes,” without taking more risk? How exactly would that get done?

   What non- traditional asset classes out-perform when stocks, real estate, gold, oil, and bonds are all getting hammered – figurines? Pin ball machines? Does e-Bay count as an asset class?