In this series of posts, I’m going to walk you through how I invest the majority of my capital in the markets. Basically, how I diversify to get better long-term risk adjusted returns than the equity market alone offers. I’ve been investing like this for about 15 years, now through a couple major equity crashes.
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.
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 for instance might be fairly 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.
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.
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
- Crude Oil
- Other commodities
- Foreign stocks
- Foreign debt
These each represent asset classes, or categories of investment vehicles. Crucially, they are influenced differently by economic forces.
For example, oil prices are driven both by global supply, which can be affected independent of the forces moving stocks, but can also move 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.