There are many painful lessons to be learned from the current economic crisis, but perhaps the most painful lesson for individual investors has been the revelation that their portfolios were not truly diversified. This lesson is especially painful because so many investors assumed that they were truly diversified before the downturn.
Modern portfolio theory was introduced by Harry Markowitz with his paper “Portfolio Selection,” which appeared in the 1952 Journal of Finance.
Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection.
Since then, many financial advisors have preached the benefit of diversification among many different asset classes. They used the theory to convince investors that they can reduce portfolio risk simply by holding combinations of instruments that are not perfectly correlated.
The idea that “diversification” will allow for the same portfolio return with reduced risk has great merit. However, the distinction between “market risk” and “portfolio risk” is important. Mistakenly, many investors thought they could reduce their exposure to an economic downturn, or market risk, by simply holding a diversified portfolio of assets.
Consider a portfolio with 20 percent spread across stocks, corporate bonds, real estate, commodities and international assets. This portfolio may seem diverse, but it is actually overly exposed to a world-wide economic downturn or a deflationary cycle, such as the one we are experiencing now.
All truly diverse portfolios should take into consideration certain macroeconomic factors, such as inflation, deflation, economic expansion and economic contraction. In other words, if you believe that all of your asset classes should rise during a period of economic expansion, you should be aware that these same assets will all likely fall during a period of economic contraction.
Therefore, to be truly diversified, your portfolio should include a healthy dose of assets that are negatively correlated with each other, as well as positions that are negatively correlated with different macroeconomic conditions. While this advice may be too late to protect you from last year’s crash, many investors are still not truly diversified to the major macroeconomic shifts that are likely to occur in the near future. In fact, some investors may be even more exposed to the looming “market risk” of inflation than they were to the deflationary cycle we are in now.
The recent flight to safety has resulted in more and more investors trading out of stocks and into cash and short-term U.S. Treasury notes. If you are an investor keeping a large portion of your portfolio in cash, you should consider purchasing some assets that will truly diversify your portfolio during a prolonged period of inflation. There are many exchange traded funds (ETFs) that can give you exposure to assets that will likely rise during an inflationary period, such as real estate, commodities and gold. Or you might even consider shorting the dollar versus all other currencies.
Although we are currently in a deflationary cycle, inflation will return at some point. It always does. When it does, cash will no longer be king.