Whenever I hear a stockbroker saying that you should diversify your portfolio by investing in stocks AND bonds, I’m reminded of the old Blues Brothers movie (the one with John Belushi). As the band arrives at a honky-tonk bar for their first gig, Elwood Blues asks the proprietor what kind of music they like. He responds that they like both kinds of music: country AND western.
Just like country and western is the same genre of music, and only one among many, stocks and bonds are similar investments and only one among many. If you want to diversify your portfolio, you need to enlarge that universe and understand when investments are truly diverse and when they are the same.
There are several keys to understanding diversification and entire books have been written on the topic, but here the focus is on three concepts: counterparties, counterweights, and counters.
Counterparties: Many investments rely on the performance of one entity to perform. The most obvious is stocks and bonds. They rely on the company issuing the stock or bond to make a profit. But if you own stocks and bonds from the same company there is no diversity. If the company goes bankrupt, both the stocks and the bonds will become worthless. The key idea here is that one company goes bankrupt and all the assets that rely on that company become worthless.
But counterparty risk is much more subtle than that. In the great recession, one company, America International Group (AIG), insured a huge number of loans that went into foreclosure. What investors in those loans didn’t realize was that if many of the loans became delinquent at once the insurance company couldn’t cover the losses. AIG was a hidden counterparty to mortgages that represented a risk to those investments. And hidden counterparties are everywhere.
We have a huge defense industry with thousands of companies who rely on the U.S. Department of Defense for most if not all their work. If there were a substantial change to our defense policy, all of those companies could be at risk. Or if there are fifty apartment buildings all focused on providing student housing, what happens to the apartment complexes if the school closes (or provides solely virtual classes)? Again, the apartment complex may be well maintained and well managed, but all the apartments in that community rely on a common party for their livelihood (the same would be true for any town with one large employer). There would be little diversification to have multiple apartment complexes in that same town even if they target different price points or demographics.
If you want to diversify, you need to watch out for single counterparties that affect many of your investments. To move away from a common counterparty risk, you may need to add geographical diversity or industry diversity or property-type diversity to your portfolio.
Counterweights: When the stock market crashes, it seems like all stocks go down, even those with companies that are doing well. There are lots of reasons for this including the prevalence of index funds that have to sell proportionally when shares are redeemed and the Chicken Little mentality of day traders. Yes, some stocks take less loss than others, but that is small consolation. Because these investments go down (or up) in tandem, we describe them as correlated.
On the other hand, there are investments that go up when the stock market goes down – and for the same reasons. Adding investments that act as counterweights when stocks fall is another important form of diversity. Precious metals, real estate, cryptocurrency, and fine art all might be hedges that are uncorrelated or even anti-correlated with stocks and bonds. (Uncorrelated means that the investment is unaffected by the other investment and goes up or down on its own. Anti-correlated is like a seesaw. When one goes up, the other goes down and vice versa.)
This principal may be applied to diversification of your investments. Look for investments that are either uncorrelated or anti-correlated with what you have. In real estate, if retail stores are going out of business in favor of online shopping, perhaps investing in last-mile delivery warehouses would be a good counterweight. If the trend continues, the warehouses will become more invaluable and mitigate the losses to the retail.
Counters: If I ask you how much you have in investments, what would you tell me? Would you say you have $10M in stocks, bond, and real estate, 1,000 doors, 50 rental properties, 1,000,000 square feet of rentable space, 1,000 ounces of gold? What are your investments denominated in?
Too many investors denominate their wealth in dollars (or other currency). Investments in currency are always devaluing as the currency loses ground to inflation. And with all the money printing in countries around the world, the potential for a collapse of currency is of substantial concern. But wealth denominated in assets maintains whatever the purchasing power of the assets is. This is the reason so many of the wealthiest in the world have placed their money in real estate. Real estate has the advantages of being something tangible that can provide an income as well as a source of wealth. And that income can fluctuate with the currency to maintain purchasing power.
An intriguing way of denominating investments may be in cryptocurrency. Cryptocurrency does not automatically devalue because of inflation. Yet, it acts like a currency (at least some types do—see my previous articles about cryptocurrency types). Cryptocurrency may provide diversification from dollar-centric investments that would hedge against a currency collapse.
Forget the lies your stockbroker told you about diversification. Remember to watch for hidden counterparties, look for investments that are uncorrelated or anti-correlated with the ones you already have, and be careful how you denominate your wealth.
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