Hedge funds, managed futures, commodities, private placements, oil
and gas exploration, non-listed REITs…what do all of these have in
common? The sellers usually claim that their product will provide the
necessary diversification for your portfolio. They claim they have
numbers to prove it, too. Here are some of the common features of the
so-called diversifiers:
- Usually illiquid (that is, hard to redeem).
- Very high expenses and fees that may be hidden in the fine print.
- Extremely high risk of losing money due to circumstances of which most investors are unaware and can not control.
- Very complex, hard to understand and difficult to research because very little information is available.
- Too good to be true returns, which simply hide the fact that these investments are risky.
But what if you get what you paid for, despite all of the drawbacks?
Do these investments really work to diversify your portfolio? Investors
are conditioned to believe that diversification is somehow supposed to
protect your portfolio from big crashes. However, in practice, we can
see that very few people were able to avoid the carnage of 2008 when the
S&P 500 index lost as much as 50% at one point. There is a belief
among professionals that if somehow we are able to assemble a number of
uncorrelated or negatively correlated assets, that is, assets which do
not move together, then we would be able to diversify away the risk of
loss when the market crashes. This sounds great in theory, but in
practice we have nothing of the sort. Everything is hopelessly
correlated in the most complex fashion, and there is nothing we can do
about it. The following plots illustrate the correlation of gold, oil,
treasuries and international stocks to S&P500 index (domestic large
capitalization stocks) in time. Negative correlation means that the
asset classes move in the opposite directions, zero correlation means
that the asset classes are not correlated in any way, and positive
correlation means that the asset classes move together.
Gold and commodities are always being touted as the best portfolio diversifiers. However, these plots
show how different asset classes (commodities, international stocks,
domestic government bonds) can all of a sudden move in sync with the
S&P500 index (higher correlation). For perfect diversification, we
want negative correlation – its great when bonds rise when stocks fall.
Zero correlation, in theory, should works too – though not as well as
negative correlation. But what we see from the above charts is that this
is not to be taken for granted, and there is no rule of thumb that is
always true. We can also see that correlation can not be reduced to a
single number, even for a single week. Week by week, the numbers can
jump erratically, and if a daily chart could be observed, we would see
the same type of erratic behavior. Because of the apparent random nature
of the correlation plots, future correlation can not be predicted, as
it constantly changes from negative to positive, making it very
difficult to make sure that different investments are truly uncorrelated
or negatively correlated, because past history does not say very much
about how correlation we can expect in the future. Thus, we can not
take the magnitude and the sign of correlation for granted. When a
crash comes, and we know crashes come quite often nowadays, correlation
between different asset classes can spike like it did in 2008, leading
to big losses across the board.
The one and only rule one needs to remember is this: the less risk –
the better. If you don’t take any risk (cash, CDs) – you will not lose
any money. If you take a lot of risks, by investing in stocks for
example – you can lose as much as 100% of your investment. Even risks
which are deemed to be low probability have to be considered when making
investment choices, especially when considering investments that are
not listed on major exchanges, as well as those that rely on extremely
speculative strategies. Investors often misprice risk, and end up paying
for it. The above correlation charts provide one reason why it is
impossible to limit your risk,and why it is so difficult to price risk
correctly. By piling on risky investments on top of each other we don’t
get lower risk – we get the same high risk associated with each of the
investments. This may not be true all the time, but when it matters
most, just like it happened during the crash of 2008, everything can
fall hard all at once. The only way to decrease risk is to put a good
portion of your money in safe investments, such as cash, CDs, and to
some extent short/intermediate term government and municipal bonds. At
some point, you will get diminishing returns, as your CD portfolio may
not meet your future needs, so some stocks and bonds exposure may be
needed, but not as much as many so-called experts suggest.
The best ‘hedge’ in this recession turned out to be cash and
treasuries, as well as bond funds which track US Aggregate Bond Index –
the most boring investments. Is it always the case? When inflation is
high, cash is not much of a hedge, and treasuries may not always be the
best diversifier, but the most important rule of portfolio management
has to always be followed – don’t risk more than you can afford to
lose. When inflation hits double digits and treasuries stop being a
relatively safe investment we will have other problems to worry about,
but in the meanwhile, there is no reason to consider fancy investments
when trying to diversify.
So whenever anybody tries to sell you an investment just remember
this: a simple, transparent and liquid portfolio can go a long way. The
opposite of the types of opaque investments described above are:
- Very liquid, sold on major exchanges, very low spread (ETFs), offered by major Mutual Fund company (Fidelity, Vanguard).
- Very low expenses, offered at low or zero commissions by the Fund company.
- Transparent risk due to the overall stock market risk, and nothing else.
- Very simple, easy to understand prospectus, clear investment strategy.
- Returns due to the market, not manager mistakes/luck.
Finding that ‘one’ gem or one investment product to make you rich is
like betting on horses. The problem is, its no good to bet on an
investment for 20 years just to find out after 20 year that this
investment underperformed relative to a simple passive index, which is
almost always the case. It is even worse when an investment turns out
to be a Ponzi scheme, or goes bust because of the risk the manager took to
achieve stellar returns. Following these guidelines will help avoid many
mistakes made by investors who are sold investments they never heard of
by somebody who managed to gain their trust with a clever sales pitch.