We have laid out both the positive Bull Market Case and the negative Bear Market Case cases for the capital markets in this newsletter. That certainly represents a lack of conviction about where the capital markets are heading. No one ever knows what the future holds in the investment world, but uncertainty seems extreme today. What’s the best approach in such an environment?
In the investment markets, desperate times call not for desperate measures, but rather for shopworn advice that often seems hopelessly quaint. You guessed it: diversification.
Over the past almost 15 years, diversification was a fool’s errand. Simply buying the largest, techiest, US-based stocks would have yielded the largest rewards. Why bother with small-cap stocks, international diversification, or Warren Buffett’s precious value stocks (what does that old coot know anyway)? FAANG1 stocks were all that were necessary to earn market-beating returns.
That has been true in other periods as well. The Dot Com Boom was a similar era of focus and concentration. Not putting all one’s eggs in one basket risked missing out on technology’s golden goose. Just as today, the phenomenon persisted long enough to make those of us building diversified portfolios look like Luddites.
Diversification also can look foolish during down markets. For example, when the Global Financial Crisis of 2008 hit, seemingly everything went down: stocks, commodities, junk bonds, international investments, etc. Diversification still seemed not to matter. After all, the only thing that goes up in a bear market is correlation.
However, many of the news stories in the wake of the last protracted downturn, and there were many, declaring the death of diversification missed one important point. Bonds went up 5.5% in 2008. That might not seem like much, but high-quality bonds were a welcome addition when stocks and other “risk on” assets were generally down 30% or more.
Today, after a long run of growth stock outperformance, we’re seeing both stocks and bonds decline in tandem, again calling the value of diversification into question. This is unusual, as bonds typically save the day when stocks crater, as in 2008. However, there has been a place to hide this time, as many alternative assets have performed quite well. So-called managed futures funds, style premia funds, and even some private real estate funds have performed admirably so far this year.
These investments are off the beaten path for many investors, but they make the case that even in the worst of economic storms, there typically are some safe harbors.
It is also likely that small-cap, value, and international stocks will come to dominate returns in the coming decade, primarily because their valuations are so much lower than the tech stocks that have been overbought Wall Street darlings for far too long.
So, while it is trite, diversification is your best bet for an environment marked by the multiple cross currents of inflation, rising rates, recession, geopolitical events, and a heightened risk of a financial crisis. It will also result in stronger performance when investments ultimately recover.
1FAANG stands for Facebook, Apple, Amazon, Netflix, and Google. These were some of the best performers during the most recent bull market.
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