At an early age, investors learn that diversification, along with a well-thought out asset allocation plan, provides sufficient risk protection against market downturns. That prescription made a lasting impression on history for decades and remains the foundation of most modem financial literature and investment theory.
A truly diversified portfolio intends to smooth out risky events by holding a basket of uncorrelated securities across various industries, commonly a mix of growth and fixed income. Many financial advisors trust a traditional 60/40 allocation of stocks vs bonds to fully take advantage of outperforming asset classes while limiting the impact of underperformers.
But in light of the financial crisis, a new trend is unfolding that defies the basic tenets of a balanced investment strategy, thereby challenging the notion of diversification. The post-crisis environment featured a prolonged period of near zero interest rates, a recovering equities market and historically low long term Treasury yields, further reinforcing the inverse stock-bond relationship.
In other words, the two asset classes maintained a strong negative correlation to which equities gained when bonds took a hit, and vice versa. That relationship only started to deteriorate in 2013, when the Federal Reserve decided to taper quantitative easing and bond buying in light of strong labor market conditions.
Trump’s election victory along with the Fed’s decisions to raise interest rates for only the second time in a decade merely exacerbated the breakdown, pushing up long term Treasuries and driving major market indices to record highs. The flippant back and forth of positive and negative correlations between equities and bonds suggests that both long term Treasuries and broad based index funds may no longer hold its standard role in a diversified portfolio.
Moreover, a shift to cyclicals and away from bond like equities following the election highlights some of the additional risks tied to traditional diversification methods (Treasuries and Index Funds). Cyclical industries like financials struggled in the aftermath of the crisis owing to increased regulation and weak economic conditions, whereas defensive stocks like utilities soared to cushion the blow of higher volatility while also offering modest dividends when bond yields faltered. But the roles have flipped to favor the former (cyclicals) and depress the latter (defensive).
While Treasuries still perform admirably when stocks tumble, it’s worth unwrapping other means of diversifying especially as interest rates start to trend higher moving forward. That can include cyclicals such as financials and industrials or small caps and gold, which many experts believe will prosper under the Trump administration.
Other opportunities present themselves overseas where a global market boom continues to unfold. The focus on Dow 20K in the past 6 months overshadowed some of the remarkable gains made in Asia, Europe and many emerging markets. Several large regional ETFs covering Latin America and Asia Pacific reached new all-time highs amid improving growth prospects.
Nonetheless, investing in international markets carries many of the same risks as domestic ones including a tradeoff between short term volatility and long term returns.
The inability of bonds to sufficiently protect against downside risk compared to other assets implies the classic 60/40 distribution of stocks and bonds may no longer hold. After all, the unstable relationship between the two in the past 3 years means bonds don’t necessarily rise when stocks fall, and vice versa.
That is to say, bonds no longer offer the appropriate amount of risk mitigation to outweigh relatively diminished returns. Investors could benefit from exploring new asset classes and allocations in constructing a fully diversified portfolio, but that of course depends on personal investment criteria such as risk, investment horizon and financial goals.
The fallout from the financial crisis illustrates that well established diversification techniques need a facelift. Simple 60/40 models aren’t as effective as they were 20 years ago. Investors must broaden their horizons beyond broad based stocks and bonds to other asset classes such as commodities, small caps, and global stocks to achieve decent returns and protect against tail events.