How to Diversify Your Portfolio Properly

April 21, 2017

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Today we have a guest post from blogger Troy at Market History. He runs a small hedge fund that invests in U.S. stocks. Instead of buying individual stocks, they invest in leveraged ETF’s. If you want to read his latest thoughts on the market, check out his blog!

We’ve all heard the standard reasons for “why you should diversify”.

Diversification reduces risk in your portfolio because it spreads money among many smaller bets.
Diversification prevents you from missing out on a big trend. For example, an investor who didn’t invest in gold between 2002-2008 would have missed out on some significant gains.

What most blogs and financial advisers don’t tell you is that there is a right way and a wrong way to diversify. If you do it wrong, you don’t reap any of the benefits! Here’s how to do it right.

You need to make sure the assets you’ve invested in are uncorrelated.

It’s one thing to buy multiple different assets because you think that specific asset classes / companies / industries will do well in the future. However, it’s wrong to blindly spread your bets among many different assets solely for the sake of diversification.

The whole purpose of diversification is to make sure that your risk is spread out and your investments are uncorrelated with each other. If the assets have a high degree of correlation, you have not diversified at all! If all of your assets go up and down in tandem, then what you’ve basically done is just invested in one asset.

For example, many people “diversify” their life savings among multiple stocks. But do they realize that this isn’t really diversification? Of course not. Since the dawn of the internet, the correlation between stocks has drastically gone up. 99% stocks go up in a bull market, and 99% of stocks go down in a bear market like 2008. What’s even worse is that correlation among stocks for the medium term has increased as well. For example, the 20% decline in the S&P 500 from May – August 2011 brought 95% of stocks down.

So if you truly want to diversify, do so between asset classes that have a very low correlation. For example,

Gold and stocks have a very low long term correlation.
Stocks and Treasury bonds have a low correlation.
Be careful of stocks and real estate. The long term correlation is significant because both stocks and real estate prices react to long term economic fundamentals.

You need to be aware of long term trends

Investing blindly is not a good idea. Sure you can convince yourself that “I’m a long term investor”. However, many companies do go bankrupt over the decades, and certain investments such as real estate are flat over a 50 year time frame (when adjusted for inflation). Hence ignorance is not a virtue.

Here’s an example. If you had invested 50% in gold in 1980 and 50% in an index fund for the S&P 500, where would you be today? Your stock portion of the portfolio would be up 2100%, but the gold portion would be virtually flat! Thus, your portfolio would have significantly underperformed someone who just invested in stocks over the past 37 years.

You need to diversify into assets whose fundamentals are bullish in the long term (or at least for the next few years). The good thing about long term fundamentals is that they’re not hard to understand!

Stocks follow the economy in the long term. Home sales is a great leading indicator for the economy. When home sales falls significantly, a recession is imminent (and hence a bear market in stocks is imminent). The U.S. Census Bureau publishes a monthly report on New Residential Sales.
Gold and silver follow inflation in the long run. So if you had seen that inflation was coming down in 1981 and 1982, you would not have bought precious metals (and would have avoided a massive bear market!)
Long term real estate is flat in the U.S. when adjusted for inflation. So if you saw that Robert Shiller’s housing index was massively overvalued in 2005 and 2006, you would have avoided buying real estate at the time.

What are the long term trends today?

The current economic expansion is becoming quite long the tooth. By comparison, only 2 other economic expansion in U.S. history have been longer. However, the good news is that economic expansions do not die of old age. They die of excess. With the U.S. economy still growing and many parts of the economy still below long term “normalcy” (e.g. housing construction is still very low), the U.S. economy will continue to grow in the next few years.

However, it is certain that we are approaching the final few years of this economic expansion. No economic expansion in American history has lasted 15 or 20 years. The final stage of an economic expansion is characterized by rising inflation because certain parts of the economy start to overheat. In an inflationary environment, physical assets such as gold, oil, and other commodities go up the most. Bonds go down because yields are driven up by higher inflation.