Even as a short term active trader, your plan should include slow and steady long term strategies. Having money work for you whether you’re working, sleeping, or off having fun is a major tailwind to your wealth and life.

In this series of posts, I’m going to walk you through a framework for investing long term, larger amounts of capital in the markets.

We’ll cover some ground about diversification and asset allocation, look at some charts to see why it works, and then create a portfolio that use the concepts.

If you read no further, just take this with you: true diversification is diversification across asset classes. Add government and corporate debt, along with inflation hedges like precious metals, and don’t go crazy on stocks only.

Diversification

Harry Markowitz, the creator of modern portfolio theory, said “diversification is the only free lunch” (even though “there ain’t no such thing as a free lunch”).

Underneath the math of modern portfolio theory and the efficient frontier, the intuition is simple: if you invest in things that don’t move in the same direction at the same time, your portfolio will experience less overall swings and realize better risk-adjusted returns.

In the modern world, a vast majority of investors simply buy into an index, like the S&P 500, and automatically diversify across the 500 largest companies in the U.S. That’s a great start, but anyone who’s got everything in SPY can tell you it doesn’t always feel like a low volatility portfolio.

As long as markets are moving along in their natural drift sideways or upwards, the value of Apple and Caterpillar might be uncorrelated. But the problem is that in a market downturn, correlations across all equities tends to move quickly towards 1 – completely correlated.

In other words, stocks move up in their own ways, but they all move down together.

That dynamic correlation in stocks presents a problem to modern portfolio theory, which assumes static correlations among instruments.

But! The basic premise is absolutely sound, if you can find more persistent relationships between assets, where correlations aren’t as subject to change. And doing that is entirely possible if we go from different stocks to different asset classes.

So a discussion of true diversification needs to be a discussion about asset allocation.

Asset Allocation

Mostly, individual investors have been taught:

  • The way to win in investing is through compound growth over a long time.
  • Higher risk assets tend to produce higher returns, and since you’re investing for the long haul, you can be comfortable with some volatility.
  • Therefore, you should invest in equities, which have high volatility but the highest returns of any single asset class over the long run.
  • You should especially do this if you’re young. If you’re older, much older, then and only then you should diversify into “safer” assets like bonds.

Look, this is reasonable advice on the surface. If I had to give new investors a single sentence investing strategy, it’s probably: Invest everything in an index fund of the stock market for 30+ years.

You’ll do fine.

But you can avoid the heartache of watching your investments get cut by 55% after the 2008 financial crisis, and waiting over 5 years to get it back.

If you were diversified across complementary asset classes, you could have taken a drawdown on your portfolio of less than 20% instead, and made it back in 18 months, and setting you up to move heavier into equities after they went on sale.

The difference in volatility and time-to-recovery between those two portfolios goes back to Markowitz’s wisdom of investing in uncorrelated returns when it really counts.

Instead of having assets that drift upward in their own ways but all fall together, what we really want is assets that rise together but counteract each other when they fall. To do that we have to look beyond stocks.

Asset Classes

So what other assets can we invest in? In short: things that aren’t domestic stocks. Here are some options:

  • Government debt
  • Corporate debt
  • Real Estate
  • Metals
  • Grains
  • Crude Oil
  • Other commodities
  • Foreign stocks
  • Foreign debt
  • Currencies

These each represent asset classes, or categories of investment vehicles. Crucially, they are influenced and react differently to economic forces.

For example, oil prices are driven both by global supply, which can be affected independent of the forces moving stocks, but also global demand, which moves with stocks as a reflection of economic outlook (a stronger global economy should generally consume more oil).

Some asset classes like government debt or precious metals are considered “safe haven” assets which tend to rise when the economic outlook worsens, as investors move money from stocks into these alternatives.

These are the kind of assets that can protect a portfolio, without the danger of trying to time the market or the cost of paying for insurance in the form of put options. In fact, these protective assets provide their own return, and including them doesn’t mean sacrificing returns.

Show me the data

In the next post in this All-Weather Portfolio series, I’ll show you some data to illustrate this introduction, and we’ll start turning the terms and theory above into a real portfolio you can start easily managing yourself.