In the world of finance, the only free lunch is diversification - so they say. Well, so says famous economist and Nobel Prize winner, Harry Markowitz. The concept that by mixing a number of different investments will, on average, and over the long-term, yield higher returns while reducing the risk. In other words, don't put all your eggs in one basket. The strategy has been used for as long as investing has been around, it's as old as the hills.
Generally, when building a portfolio, investor's hold a portion of Defensive assets such as bonds, and a portion of Risky assets such as stocks or real estate. The Defensive assets help cushion the portfolio from the ups and downs of the Risky assets. And today, diversification has been pronounced dead.
The last 20 years have seen both bond prices and stocks rise, together. It hasn't always been like this. During the 30 years prior, when inflation was higher, bonds and stocks moved in opposite directions. For the last 20 years, investors haven't had to do much to be rewarded handsomely for holding both bonds and stocks. During this time however, investors had to endure multiple stock market collapses, a Global Financial Financial Crisis and a 1-in-100 year pandemic. And now we are facing the one thing we have been seeking for the last decade and a half - inflation.
In the chart below, you can see inflation (red line) jumping for the first time in a long time. Why this is worrying the experts is because with rates at zero the only way is up. And if we are moving into negative correlation territory (as illustrated by the green line rising above zero), meaning stocks and bonds move in opposite direction - and if bonds are rising, then stocks must fall.
This is the nightmare scenario for investors, stocks and bonds falling together. This isn't impossible, it's happened before. In fact, it happens all the time over short periods of time. The last 100 years of data tells us a thing or two about investing, markets, and human beings.
Since 1926 (US data):
Stocks and bonds were both negative on 16 occasions, or 1.41% of the time.
Stocks were down and bonds were up on 260 occasions, or 22.90% of the time.
Stocks were up and bonds were down on 103 occasions, or 9.10% of the time.
Stocks were up and bonds were up on 757 occasions, or 66.60% of the time.
The real question is, for how long? If investors are selling stocks, and selling bonds, where is the money going? Cash? Maybe. For a short period of time. Gold? Crypto? I'm not ruling this out. But for how long!? If investor want to participate in real productivity, ownership of real businesses, and real long-term growth, these aren't forever homes, they're move like weekenders. And before you say it, I will. Interest rates have never been here before. And so while we may be on the verge of the nightmare scenario, I still think diversification is the only free lunch in town. Let's just say the death of diversification was not declared by the doctor.
I spoke about this and more with Richard Quin on the Masters in Investing podcast last week.