On zigging and zagging: Does diversification still work?
Okay, about yesterday...
Big stock market drops force financial reporters to crank out the cliches. Back when I did more of this kind of thing, I used to joke with my editors that I should set my word processor to enter a few time-saving stock phrases with just a few keystrokes. Like so:
Alt + Shift + F1: "Investors are taking some money off the table."
Alt + Shift + F2: "Sellers crowded the exits."
Alt + Shift + F3: "Two forces drive the market, fear and greed. Fear was in the driver's seat."
Alt + Shift + F4: "Stocks just went on sale."
Alt + Shift + F5: "A technical correction on strong fundamentals."
Alt + Shift + F6: "It's like somebody somebody blew the dog whistle/snapped their fingers/lit a match."
Alt + Shift + F7: "Although today's drop in the Dow seemed large in terms of points, in percentage terms it was only..."
Today I've been thinking about another cliche we money journalists use a lot: "zig when the market zags." (By "we" I mean, of course, me.) We say this when we're trying to explain the benefits of diversifying your portfolio across lots of different kinds of assets. If you hold shares in a
Well, yesterday China's stock market zaaaaaaaaged.... and European and U.S. markets got pretty well zagged, too. This is unusual only in degree: Over the past several years, global markets have become more correlated with one another. That's partly because technology and financial innovation make it easier for investors around the world to invest, well, around the world. Maybe it's partly because of hedge funds. (That's another popular cliche these days. Hedge funds also kept me out of Harvard, maxed out my credit cards, and made me miss my deadline last week.) And it's probably also because most assets have been pumped up by the same two global trends: easier money and higher investor risk tolerance. (Time's Justin Fox has a sharp, brief sum-up here.)
There are two common rationales for diversification:
--Over the long run, you will get a better return with lower risk. My guess is that this is probably still true as regards international diversification, though of course we won't know that for sure until some kind of "long run" is over and we can run the numbers. But recent experience strongly suggests that just buying some European and Japanese blue chips probably isn't enough to diversify away from your S&P 500 index fund. If you want a really low correlation, you'll have to be more adventurous, and should consider assets besides equities.
--In the short term, it might keep you from panicking. The idea here is that if you have something in your portfolio going up or holding steady when the U.S. market falls, you won't be so tempted to sell in a frantic effort to hold back your losses. This is a rationale cited more often by the brokers and financial planners I talk to, and not so much by economists. I don't know if there's any real proof that this actually works, even when you get the zig/zag effect. (I'd be delighted to hear from you if you have some.) But diversification clearly didn't protect your sanity yesterday. If you had 10% of your portfolio invested in an Asian emerging markets fund yesterday, I'm pretty sure you felt worse than the rest of us. As another Wall Street cliche goes, diversification only works when you don't need it.
If you want to avoid panic, here's a better idea: Set up a well diversified portfolio that suits your risk profile and then do your best to ignore the thing. (You can rebalance once a year or so.) Make it rule than when the market drops more than, say, 200 points, that's the one day you will absolutlely NOT check your account.
You do realize you can diversify into investments other than equities, right? And that bond prices go up when equities go down, right?
I know that diversification still works. But, and you touched on this key word in your article, it's the correlation that really matters. If you own Home Depot you can't just buy Yahoo and assume you've hedge your bet. You really have to find a buy that has as close to a zero correlation to your portfolio as possible but is still trending up. That way, no matter which way your portfolio goes, you could still make some green. Diversification requires a lot more research and analysis then it used to. Needless to say, with the high volatility in the market, investing in 2007 is not for the faint of heart.
By being more adventurous, you have to be willing to take on more risk. Studies have proven that just buying large cap international stocks doesn't pack the same diversification punch as it yet used to. However, adding lower correlated international small caps (See David Herro at Oakmark International Small Cap) and emerging market stocks through a diversified fund or ETF will help over the long run. There is also the emerging area of international real estate.
You mention that persons wishing to diversify: "If you want a really low correlation, you'll have to be more adventurous, and should consider assets besides equities."
Aside from bonds, which don't seem too adventurous, what assets other than equities are you referring too?
Are you proposing that persons invest in real estate, or perhaps an Real Estate Investment Trust or REIT mutual fund?
Or do you suggest that persons invest in precious metals such as gold?
Though your article is interesting, I wish there was more tangible advice.
In the current environment, (i.e. slowing growth and increasing inflation), three out of four asset classes will be lower--bonds will be killed, stocks lower, and real estate will continue its decline. That leaves only one area with negative correlation--commodities. Consider putting more of your portfolio into commodities for protection. Stagflation may be here.
A lot of people over-estimate their risk tolerance; it takes a few serious hits (on paper) to learn how you react emotionally to volatility (vs. intellectually, before it has happened).
Diverse porfolia always good for people with moderate risks. But how much of internationa and US stocks you should hold depends with your picks. With so volatile market (specially what happened yesterday!) its hard to keep any international stock!!
Call me stupid, but I think you might be missing the author's points. It's fair to assume as some ask that he's aware of the very different kinds of products which one can buy to diversify out of risk, or indd into it. But the point seems to be to reconsider whether your portfolio is actually diversified or just fulll of different equite and in that respect he seems to have done a fine job.
I wish all stories on diversification would qualify it by stating they are not talking about long-term investing. Basically, the S&P 500 beats overseas markets in the long term.
Buy and hold long term investors should ask themselves, "The market crashed - so what?" Over the long haul they will still make money.
Short term buy and sell types should have sold everything when the market was posting all those record highs this month. Then they wait for this 'crash' and buy again.
Sell high. Buy low. Radical, right?
If an investor in Equity markets cannot sleep well after 3% drop then I guess he/she is in wrong place. It's time to revisit the risk profile. In my view drop like this will test the nerves of diversified investors whether their risk assessment is appropriate or not. In a booming market invesors overestimate their risk appetite and go for higher equity allocation.
I agreee that just international large cap with S&P 500 is not enough for diversification. Also it does not hurt to have some bond allocation in AAP.
Most journalists continue to report point drops rather than percentages. This is the math illiteracy, and it warps public perceptions.
I lived through the 1987 crash. 23% in one day, so 3.5% isn't going to spook me.
Don't forget that diversification includes cash and cash equivalents, such as I-Bonds. They help give peace of mind.
I appreciate your comments about diversification. My portfolio is 67% rental real estate, 25% stocks and 8%bonds. I invest in market ETF's for the equity markets - 35% S&P500, 35% MSCI EAFE, 18% TSX, 10% Nasdaq, and 2% in the Hang Seng. I sleep pretty well most nights, by reminding myself that I'm in the accumulation phase of life, and market corrections represent buying opportunities. I buy monthly through payroll deduction and rebalance by reallocating the purchase percentages. Occasionally I contribute a lump if I need a bigger rebalance.
I would like to get some good quality historical annual return data on those market indexes (indices?) so I can check to see how far my mix has strayed from the efficient frontier for my portfolio. Is there a website where I can find that information?
Yahoo is always a good place to start. You can get data for the S&P back to 1950.
Diversification is for people that don't know what they are doing -Warren Buffett
Gee, I thought this blog was about diversity...but at least I can spell and proof my comments before exposing them to the world. I found the most thought provoking comments to be those of Denis (Houston, TX), and the quotation attributed to Warren Buffet.
I simply try to keep an eye on, to me, the most important factor in any long term (more than 10 yrs.) investment program and that is the number of shares that I've been able to aquire, not the value of them this very minute. I admit, it adds to my graying hair, but when I realize the shares themselves become more conservative over time in the Target-Retirement fund, then I simply think of the couple of extra dollars a month that they will be paying each time I pick up a few extra shares each month when the price drops. I also try to remember back at the end of 2002 when no one was predicting the run about to happen that it would have been great to have plunked down a bit extra each month to have grabbed some discounted shares!
The other day's global decline in stock prices was a "flight to quality" event. Stock sellers re-invested their proceeds in high credit quality bonds, therefore stocks went down and bonds went up. The best and cheapest equity diversifiers in such cases are money market funds, Treasuries, investment grade munis, CDs and E & I-bonds.
I don't diversify, I focus. Have between 5-15 holdings at any one time. Have beaten the S & P every year since Jan 1, 1999. Of course, focusing means that I know my investments quite well, and that I must pay attention, something that does take time. But, the rewards are worth it.
Buying an index fund will beat 70-80% of other funds. Why does this strategy work? Though indexing will capture the downturns, it will ALWAYS capture the upswing in prices, and that's the key. Like this past week, people might get out of the market but they don't always get back into the market at the write time. For lazy or risk averse investor, this is probably the best choice.
Actually the main reason index funds beat most actively managed funds is because of the low fees. Most actively managed funds average about the same as index funds before fees so naturally, once you subtract their higher fees, most of them underperform.
Think about commodity futures (Goldman Sachs Index)as the way to diversify: they have a negative correlation with stocks and bonds over most time horizons. Read Facts and Fantasies about Commodity Futures.
Leon in Waco could be wrong. Bonds go up when interest rates go down.
Just pretends it is early in the new year.....
I just checked the year to date returns..on all my accounts...
Looks like I am up still up 1/2-1% for the year... So last week just knocked me back to January...
We just gave back a couple of our recent good months. Good luck beating US Stocks for the long haul. I'm in for the next 30 years at least.
(Maybe some private equity buy-outs will even prod Detroit to compete with the Japanese and make some good American cars!)
Investors seem to have forgotten the rise in international stocks from september till now.Look for long term returns. There is no road traveled without a little pothole!
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