What’s The Deal With Diversification?

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In our last article, we talked about the nature of risk and return. Why is there money to be made in investing your funds, instead of stuffing them under the mattress? As we found, accepting the risks of putting your money into certain assets gives you the ability to collect risk-premiums.  We also emphasized that the best approach is to invest across an entire asset class through a passive index, so that you can collect its associated risk-premium. Short-term speculative plays not only expose you to specific risks which are difficult to predict or model over time, but they could also be bad for your blood pressure.

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Dar Sandler                                                            Davide De Micco

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You might also remember another earlier article, where we pointed out some of the shortcomings of the traditional 60/40 approach (60% stocks, 40% bonds) for investing, and why that model doesn’t fully deliver on its promise of diversification. But if the 60/40 approach doesn’t hold water, what is the best way to diversify?

Let’s step back for a moment. Why diversify in the first place? There’s only one core reason to put all your eggs in different baskets:  because you want to make sure that if one investment loses money, others do not.

That might seem simple, but let’s dig deeper. How do you know which investments will do well when others take a sick day?  This leads us to the idea of “correlation”, the measure of how the movements of two investments relate to each other.  Low correlation means it is difficult or impossible to see any similarity in how two investments rise and fall over time. If diversification is what we want, then this is a good thing.

You might now think that all you need to do is find as many “lowly correlated” asset classes as possible, spread your money across them, then call it a day and start planning an early retirement.  The problem, though, is that correlations change over time.  Sometimes each asset class will march to the tune of its own drummer, but other times they parade in lock-step.   It looks like correlation alone isn’t going to help us create a diversified portfolio. Is there a better framework?

Don’t worry…the answer is yes. Let’s pause for a moment and return to the topic of investment returns. There are two fundamental drivers of asset class returns: growth and inflation. By Growth (sometimes called Real Growth), we mean how the U.S. economy’s total output of goods and services is actually changing each year (excluding inflation). Inflation measures the rise of the cost of goods and services in the U.S. economy. Or to quote the famous economist Milton Friedman, inflation is when you have “too much money chasing too few goods”.

At any given time, the prices across an asset class reflect the market’s current expectations for growth and inflation. In other words, the prices for each asset class have “baked-in” expectations for growth, inflation, or both.

So what happens when growth or inflation are different than expected?  Prices swiftly adjust to new expectations. These continuous changes in prices create returns.

The charts below show how four key asset classes have performed as growth and inflation came in above and below expectations. Columns are colored blue to emphasize outcomes that we will be discussing in the paragraphs below:

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*Data was compiled using Bloomberg total return indices for the respective asset class minus the cash rate at the time.

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Let’s dissect each of these asset classes and see why what we are seeing actually makes sense. Remember, we are always talking about expected growth and inflation, not what the current level looks like.

1. U.S. Treasury (Nominal) Bonds:
   1. Inflation – When inflation is lower than expected, bond prices will rally.  Bond yields also drop (remember the inverse relationship between price and yield).  Essentially, the bond yield previously reflected the market’s over-estimation of how much the investor needed to be compensated for inflation. Now that inflation will be lower, the yield can be lower too, and prices will rise.
   2. Growth – When growth is below expectations, the central bank will often loosen interest rates (i.e. the cost of money) to help boost the economy. Lower interest rates lead to higher bond prices.  In this situation, investors will also sometimes move their money to safer, more stable assets like U.S. government bonds. This “flight to safety” means more demand for treasury bonds, thus higher bond prices as well.
2. US Inflation-Linked Bonds:

1. Inflation – Unlike regular Treasury Bonds, Inflation-Linked Bond returns are tied to both actual inflation and expected inflation. When inflation is higher than expected, their nominal coupon payments are now worth more, as they are indexed to inflation. At the same time, the sudden higher demand for “inflation protected” assets will also drive up prices in this asset class.
2. Growth – Same story here as in U.S. Treasury Bonds. Expectations for economic growth determine expectations for changes in interest rates, which in turn drive bond prices.
2. Commodities:

1. Inflation – Historically, commodities have been a great hedge for inflation. After all, changes in commodity prices are part of what determines inflation itself! As inflation comes in higher than expected we will see commodity prices adjust across the board.
2. Growth – When growth is higher than expected, this means companies are producing more goods and services. That increase in production means they are consuming more supplies and raw materials. Higher demand for the same amount of goods leads to higher commodity prices.
3. US Stocks:

1. Inflation – Lower than expected inflation means lower interest rates – it is now cheaper for companies to borrow money. Additionally, the present value of their dividends is now higher (as they are now discounted by a lower rate). These two effects cause stocks to rally.
2. Growth – If growth comes in higher than expected, stocks need to adjust to the new “growth factor” that is embedded in equity prices. The market rallies as a result.

Of course, we are only giving you the basic principles explaining why each asset class performs better or worse in any given environment. Suffice it to say there’s a lot more to cover in this area, and we will revisit many of these concepts in future articles.

Next, we need to take some of the findings above, and add in our understanding of return’s evil step-brother, risk. We will build a properly diversified portfolio that targets a specific overall level of risk.  How do we do that?  Stay tuned for our next article!

Edited by: Simon Cartoon

www.appianroad.com