Diversification
One of the most important concepts you will ever learn in finance is diversification. Everyone lives and dies by this concept in professional investing. This concept will save you many times during your investing life.
To understand diversification, we need to first understand what it is built on: correlation. We all studied the concept of correlation at one point or another in school. It is nothing fancy really: it is simply a number that measures whether two things, two stocks for example, move the same way or not. Do they always go up and down together? Or when one goes up, the other tends to go down? This correlation number is always between 0 and 1: at 0 it means the two things you measure, the two stocks, or one stock and one bond, or two stock indices, or stocks and oil, have no correlation. This means they always move in completely different ways. At 1, they are perfectly correlated: this means they always move the same way. If one goes up by 0.5, the other one also goes up by 0.5. And if one falls by 3, the second also falls by 3. Their movements are basically identical.
Two highly correlated stocks: they go up together:
Two highly uncorrelated stocks: as one increases in value, the other decreases:
Of course, you might think that the goal is to always have highly correlated investments that go up together. We all want this. But in reality, all investments — stocks, real estate — go up and down over time. And the entire idea behind diversification is to have a portfolio of investments that don’t all go down together at the same time. We all know that stock market crashes happen. So the question becomes when the stock market crashes, how do you avoid all your portfolio of investments crashing? And the answer is by having a diversified, uncorrelated portfolio. Let’s look at some examples:
· When stocks crash, government bond prices tend to go up, as investors fly to safe assets (they sell their equities and invest in government bonds instead)
· When stocks crash, gold tends to go up, as investors fly to this safe asset
· When stocks crash, some stocks, called “defensive” stocks, tend to go down a lot less than others — this is because no matter how bad things get, people will need soap, detergent, toilet paper, food. Luxury cars and handbags, maybe less so.
Let’s look at how different investment assets, usually assumed to be uncorrelated during crises, actually performed during the last 10 financial crises:
See, in average, during the past 10 financial crises, US stocks fell 22%, while US government bonds increased 4%, and gold increased 8%. It is obvious that a mixed, diversified portfolio, with all 3, will have performed better than a portfolio of 100% stocks. And when your portfolio falls less, it also needs to increase a lot less in order to recover its previous value, so you recover quicker, and start compiling gains again quicker.
All assets have ups and downs. This is why you should never put all your eggs in one basket. Traditionally, a common advice was to have 60% of your portfolio in stocks, and 40% in bonds. Even better would have been to also have gold in there, as you see above. On the one hand I am more aggressive in my portfolio since I have a very long investment horizon. On the other hand bonds nowadays hardly return anything. So my portfolio at the time of writing is a mix of stocks and commodities including gold. I have about 5–10% of my portfolio in gold. It hasn’t done much for me over the past years — didn’t really go up or down. But this is my little portfolio diversifier/hedge. If the apocalypse happens, at least one part of my portfolio can be expected to go up. If US government yields go up, and bond prices fall (bond prices always move in the opposite direction to yields i.e. if yields increase bond prices fall and if yields decrease bond prices go up), I will happily buy some US bonds as well. Don’t forget though that whatever you use to diversify your investment portfolio, it needs to be meaningful. It doesn’t make sense to have 99% of your portfolio in stocks and 1% in bonds or gold — this is not diversification. You need a significant amount of bonds or gold in your portfolio for it to protect your portfolio when stock prices crash.
Correlations capture the extent to which two assets move together, or in opposite ways.
You never want to have all your eggs in one basket.
On the contrary you aim to have a diversified portfolio.
This means allocating part of your portfolio to investment assets that move differently, are uncorrelated, from the bulk of your investment portfolio, which will typically be stocks.
Assets uncorrelated from stocks tend to be bonds and gold.
You need a meaningful amount of one, the other, or both, in order to protect you in times of crisis.
Look at the numbers above, and see what different portfolios, with different weights allocated to stocks, bonds, and gold, or any mix thereof (stocks and bonds, stocks and gold…), would have done during each of these crises. Choose the one that you feel comfortable with.
