Diversification: Making Money When Markets Freak Out

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Includes: AGG, DBC, DIA, EEM, EFA, GLD, IAU, IEF, IWM, LTPZ, MDY, PDBC, QQQ, SPXL, SPY, TIP, TLT, TMF, TQQQ, TYD, UGLD, UPRO
by: D.M. Martins Research
Summary

When markets panic, I get reminded of the benefit of a multi-asset class approach to investing.

For a long time, I have been a proponent of betting on stocks, treasuries, gold, commodities, maybe REITs and other alternatives - all at once.

In this article, I present two portfolio allocation strategies that should produce better risk-adjusted returns without the market jitters.

I believe that thinking outside the box is key in creating better investment strategies.

Every so often, I get reminded of the value of holding a diversified portfolio. Best of all, it usually happens when every other investor around me seems to be frantically biting their fingernails in desperation.

In the week ended August 2, the S&P 500 (SPY) had its worst performance of the year so far, down -3.1%. All it took was a series of bearish Presidential tweets about trade policy on the first day of the month for the S&P 500 companies to collectively lose more than half a trillion dollars (that's right, with a "T") in market value in a matter of three hours. Following the expected retaliation by China on Monday, August has quickly become the worst month of returns in the equities market in 2019, already down about -4.5%.

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The benefits of diversifying across asset classes

I have often written about the benefits of diversification as a strategy to minimize the undesirable impact of volatility and portfolio draw-downs. Over time, I believe the approach will produce superior risk-adjusted returns. The first time that I discussed the idea on Seeking Alpha was back in April 2016 - when almost no one seemed to care about taking a more defensive stance towards investing, given the long-lasting bull cycle.

As a fan of hedge fund mogul Ray Dalio and his investment philosophy, I have been a proponent of investing across asset classes for the long haul - i.e. stocks, treasuries, gold, commodities, maybe REITs and other alternatives. The idea behind spreading one's bets is to reduce correlation among investment returns and smooth out the portfolio's performance through different macroeconomic environments. The concept may seem odd to many, since most of us have become accustomed to associating growth investing with an all-stock strategy.

Two portfolio allocation ideas

In 2016, I presented Mr. Dalio's simplified, retail investor-friendly portfolio allocation that, theoretically, should produce solid returns without the adrenaline rush of the stock market's roller coaster ride:

  • 30% stocks, whether concentrated in the U.S. or diversified globally
  • 40% long-term treasuries
  • 15% intermediate-term treasuries
  • 7.5% gold
  • 7.5% diversified commodities

Depicted below is the performance of the portfolio described above since 2007, the earliest date for which I have reliable data on all asset classes (blue line labeled "Portfolio 1"). Notice that the strategy (1) produced very smooth returns, even during the Great Recession and the short-lived bear attack of 4Q18 and (2) dipped only -4% in its worst year vs. the S&P 500's much more damaging -38% in 2008. In risk-adjusted terms, Portfolio 1 performed substantially better than an all-equities portfolio, as evidenced by a Sortino ratio of 1.3 vs. the latter's 0.8.

Source: Portfolio Visualizer

Also evident above, Portfolio 1 failed to produce better absolute returns over the 12 year-long period compared to the equities benchmark: 6.5% annualized vs. the stock market's 8.4%. To address this issue, I believe the more sophisticated investor can still take advantage of the less risky, multi-asset class diversified approach - but might need to "dial up" the expected returns of the portfolio. This can be achieved through futures contracts, options or, more simply, leveraged ETFs.

For example, in early 2017, I put together a sample portfolio that I have named SRG Base (the acronym stands for "storm-resistant growth"). It holds primarily ETFs, some of them leveraged, along with some individual stocks. Currently, the portfolio is allocated across asset classes roughly as follows:

  • 45% primarily U.S. stocks
  • 110% treasuries, some of which inflation-protected
  • 22% gold and other commodities

Notice that the portfolio is currently leveraged by a factor of nearly 1.8x (simply add up the percentages above). Counter-intuitively, the portfolio's leveraged profile has not led to higher risk and volatility. Instead, the SRG Base's key feature has been much smoother returns than what the S&P 500 has been able to produce lately, with "higher lows" during periods of market distress.

For instance, in the week ended August 2, the SRG Base was minimally up +0.2%, while the S&P 500 produced returns of -3.1%. During the bumpy month of May, something similar happened: the SRG Base stayed largely flat, while the broad equities market was down -6.4%.

Key takeaway

In my view, stock market pullbacks are a great opportunity for growth investors to pause and think more deeply about their portfolio allocations. Traditionally, "buying the stock market" and holding the assets over many years has been the default approach.

However, I believe that thinking a bit outside the box is key in creating a better investment strategy - one that eventually leads to better risk-adjusted returns and better nights of sleep.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.