Diversification
...excerpt from Mo Lidsky's latest book, Partners in Preservation
Most investors cannot possibly achieve their goals without exposure to a diversity of asset classes. For investors who would like to see their portfolios stand up in almost all market conditions, there is nothing more fundamental than allocating funds across different and varied asset classes where value is derived from fundamentally different sources.
There is no shortage of data that shows why this is important. The most common reason is that there may be decades of certain asset classes producing negative to flat returns. Take, for example, the Canadian real estate market in the early 1990s or North American equities in the first decade of this millennium or even most of the years between 1960 and 1980. For the purposes of wealth preservation, the goal should be exposure across a wide array of asset classes.
Truly anything can happen at any time, and while we cannot predict the unexpected, we can certainly immunize ourselves (to an extent) from its impact. Thus, only by diversifying across most of the asset classes can an investor achieve the highest probability of preserving capital through all market conditions.
Some of the best investors in the world consistently plan for the unexpected. Howard Marks, the legendary investor and chairman of Oaktree Capital Management, once shared a story that deeply impacted his investment philosophy. He talked about a particular gambler who once heard about a race with only one horse in it. He saw it as a no-lose proposition, so he ran straight to the bookie and bet everything he had on the horse. Halfway around the track, the horse jumped over the fence and ran away, taking with it the gambler’s last penny.
Research has shown that price changes do not follow a normal distribution. Extreme events happen considerably more frequently than their standard deviation model might suggest. Michael Mauboussin uses the example of Black Monday in October 1987, the result of which was twenty standard deviations away from the mean. As Jens Carsten Jackwerth and Mark Rubinstein pointed out,
“Economists later figured that, on the basis of the market’s historical volatility, had the market been open every day since the creation of the Universe, the odds would still have been against its falling that much in a single day. In fact, had the life of the Universe been repeated one billion times, such a crash would still have been theoretically ‘unlikely’.”
Other legendary investors have molded their investment philosophy around the unexpected. For Nassim Taleb, author of The Black Swan, every investment decision is painted by the prospect of the unexpected. He shares a story of a turkey that has been fed by a farmer for one thousand consecutive days. By this point in time, he has come to accept the fact that when the farmer shows up, he (the turkey) will get fed. To the turkey’s awful surprise, on day 1,001, just before Thanksgiving, the farmer arrives not with feed but an ax.
Taleb is echoing the words of David Hume and Bertrand Russell, who claimed that inductive reasoning is a poor predictor of the future. Time and time again, we are humbled by the unpredictability of the market. Things that we couldn’t imagine yesterday can easily become today’s reality.
Daniel Kahneman, psychologist and author, demonstrates that people will envision risk to be only as bad as something they’ve witnessed or experienced. They cannot grasp the concept of something worse occurring until it does and thereby rarely prepare accordingly.
In 2008, the “safe assets” surprising us were in real estate, including all the financial vehicles that supported the supposedly stable housing market. More than half of the losses of the global financial crisis in 2008 were attributed to collateralized debt obligations (CDOs) of the housing market. Of these CDOs, over 28 percent of those rated AAA by at least one of the top three US rating agencies had defaulted. These investments were considered safe by all accounts, and housing prices were projected to go nowhere but up. There was no convincing the average American that over the long term returns on single-family housing were not greater than the after tax rate of inflation. In fact, Nobel Prize–winning economist Robert Shiller found that over the 114-year period culminating in 2004, the real prices of homes were mostly flat or declining, providing a total increase of 66 percent, or an annual increase of 0.4 percent, which is far below the rate of inflation.
Today, the “safe assets” surprising us are bonds. While 2000 through 2010 has been referred to as the “lost decade” for stocks, it has certainly been the “discovered decade” for bonds. From the year 2000 to 2010, bonds have been the best-performing asset class at just under 7 percent per annum. Today, we take for granted how much of a bond bull market the last thirty years have been. If one looks at bonds in a proper historic context, one will see that in 1916, in the midst of World War I, the Russian army was borrowing money at 6.36 percent. In 1922, amid extreme hyperinflation, Berlin was borrowing at just over 6 percent. Even the army of the Confederate States was borrowing at 6.7 percent in 1861. It can be said, then, that the bond market in times of relative calm, notwithstanding the crash of 2008, has been as good as it gets. Once an asset approaches “as good as it gets,” however, there is usually only one place left to go. As interest rates rise and the Federal Reserve cuts back their quantitative easing programs, the illusion of “safe assets” will eventually fade, leaving shocked and disappointed investors in its wake. This was foreshadowed in the final days June 2013, when interest rates experienced a small spike and the prices of virtually all “safe assets,” such as treasuries, mortgage REITs, and long-duration bonds collapsed in the markets.
This analysis does not require a PhD in economics to figure out. Over the long term, we have a pretty good sense of expected ranges of performance from each asset class. Thanks to a whole host of technology solutions, one can simulate thousands of different market scenarios, allowing us to gauge just how far from historic norms we may be in any particular asset class.
It may take a while, but the landscape inevitably shifts, and there will always be a reversion to the historic mean. Bonds will come back to earth. Going forward, investors cannot approach fixed income as they have the last thirty years, and alternative solutions must be approached. However, it is not just fixed income. In general, only by being truly diversified across the breadth of asset classes, such as real assets, credit, and private equity, can we shield ourselves from the fallout of those inevitable shifts.