Free Lunch

This article was first published in the National Post on March 5, 2022. It is being republished with permission.

by Tom Bradley

There’s an old saying that diversification is “the only free lunch in investing,” but I’m beginning to wonder if that’s still true.

This well-worn adage reminds us that holding a mix of assets driven by different economic factors, and following different paths and sequences, will generate a return with less volatility.

In your stock portfolio, that means holding different types of companies that operate in a variety of industries and geographies. It’s the same with your bond holdings. Air Canada’s debt has a nice yield, but has been known to hit air pockets occasionally. Overall, you want to own assets that have little or no correlation with each other.

There’s another feature of diversification that’s often overlooked. In addition to smoothing out returns, it takes capital loss out of the picture. No matter how severe a bear market is, or how long it goes, you can be assured that you’ll fully recover with time.

That’s not the case if you own a handful of stocks in a few high-potential, high-risk industries. Your portfolio may never recover if the thesis you’re betting on proves to be wrong.

Correlation chaos

Despite its benefits, diversification is facing challenges (hence, my wondering). In today’s markets, we’re experiencing what I can only describe as correlation chaos.

The stock market’s most reliable diversifier, high-quality bonds, has let the side down. Bonds have been declining with stocks. Meanwhile, high-yield, or junk, bonds, which have historically been highly correlated with stock-price movements, have held up better than investment-grade bonds.

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Gold has also failed to live up to expectations. Inflation spiked last year and yet the price of bullion barely moved. It only came to life when a war with Russia was looming.

Then there’s bitcoin. It’s supposed to be the new gold, but it is trading in sync with high-risk tech stocks. And that’s probably understating it. It’s trading more like an option on a tech stock.

Time frame

Of course, time frame is important in any investment discussion. With diversification and correlation, you need to differentiate between intense crisis periods that last a few days and longer-running bear markets that last for months or years.

In times of panic, widespread fear causes mass selling that, in turn, causes a liquidity crunch. It’s as if everyone wants to escape a burning building and there aren’t enough exits. Everything goes down and correlations all go to one (that is, all assets move in unison). This is an asset allocator’s worst nightmare as their elaborate models are rendered useless.

One of the shockers during the COVID-19 crisis in March 2020 was that United States Treasury bonds, the ultimate safe asset, traded poorly in the first few days of the meltdown. Complex hedge-fund strategies were being unwound and Treasuries were collateral damage. After the initial squeeze, however, they got back on track and did their job in the weeks that followed.

You can’t predict moments of panic so you can’t avoid them. All you can do is know they’ll happen every five or 10 years and mentally prepare. In these situations, being diversified won’t prevent the declines, only moderate them.

For bear markets that grind on, however, it’s a different story. With time, correlations normalize and the benefits of diversification emerge. Your portfolio will be more resilient and allow you to sleep at night, and maybe you’ll even buy some bonds and stocks at reduced prices — if you have the stomach for it.

Cheap lunch

Still, building a diversified portfolio is tougher now than I can ever remember. The historical relationship between asset classes has been shaken and negative real interest rates on bonds and guaranteed investment certificates make it more expensive. In other words, to dampen volatility, portfolio return has to be sacrificed.

With the unattractiveness of conventional bonds, other more exotic fixed-income instruments and alternative strategies are being offered as substitutes. These products can provide an attractive long-term return, but are generally not good diversifiers for your stock holdings.

Higher-risk debt (high-yield bonds, private debt) is highly correlated to stocks and alternative strategies (long-short equities, convertible and equity arbitrage) are what I call “unpredictable diversifiers.” They may shine during one market storm and do miserably the next. In many situations, these strategies are better substitutes for stocks than bonds.

OK, I’m willing to accept that diversification isn’t free anymore. But make no mistake, it’s still a bargain.