Nod to Diversity

So far my diversity play is working as I expected. Today the S&P is down .85%, and my diversifiers are all up, GLD ^ 1.5%, Cash (BIL) ^ .01% (but cash is in an interest bearing account.), EDV ^ 1.1%, and BTC ^ 8%.

GLD EDV and BIL represent stability. BTC replaces the volatility I lost from selling stocks. The % I own of each asset adds up to a portfolio located on the efficient frontier, and with a Sharpes ratio of >1 (about 1.5:1). My overall portfolio risk remains about 10% (9.5%). Since each diversifier is only a “small percent” of my equities exposure, I’m still largely concentrated in equities. If the bull continues I’ll be riding the bull. If the crash comes I expect the diversifiers to act as a parachute. If the crash is severe and lengthy the money in the non stock pots should sustain me going forward.

2 Replies to “Nod to Diversity”

  1. Hi Gasem – I really enjoy your blog. It has some real meat, and you are doing those of us who have a few questions beyond 4/25 or 3/33 and “invest in 100% equities” a real service.

    I have thought a lot recently about asset allocation, and I am learning about MPT and the efficient frontier. The question is somewhat related to this post and the previous one about Michael Burry. What happens when investors (me, and you from what I can gather) are indexing into bonds and the market tanks? As an example, I own 40% VBTLX in my 401K. If a lot of investors pull out for whatever reason (rebalance, panic, etc. in the event of a correction), aren’t bond index funds screwed like the stock ones? There is a lot of money in these funds as well, and every month (or 2 weeks), the automatic contribution of most people kicks in.

    Hypothetically, and not at all as an investment recommendation, do you think it be wiser to spread the bond portion around to specific etfs/funds that only go after certain maturities/countries, or do you think that the risk of these total market funds is spread enough that it won’t matter so much a couple of years after a market correction? I notice you are in EDV and cash (I agree that CIT is a good account, and I’m using this in lieu of short term bonds or t-bills in my taxable accounts). I don’t have the option in the 401K, but I do in the taxable.

    Also, I think the interest rates of TIPS cannot go negative. I’ve been looking at them as a possibility for longer term, but I haven’t pulled the trigger yet. If we go negative because of the coming “correction”, this may be an alternative.

    Thanks again,

    1. Hi John

      Bonds and stocks are uncorrelated. Yes bonds constitute a market that has it’s own characteristics. The thing that links bonds and stocks are people. Stocks are risky and bonds are risky but stocks are more risky so when people become afraid of stock risk but still want to own some risk they often move into bonds. As money pours into bonds their value increases in the market. Someone may look a bonds with a 2% interest and scoff, but they have no problem owning the S&P with a 2% dividend. The S&P has a 15% risk and a 2% dividend vs a bond that has a 4% risk and a 2% interest what’s the better deal? If people are moving into bonds it’s worth owning some bonds IMHO. It reduces the concentration of only stock exposure. When equities crash the bonds still hold value. Cash is another non correlated asset. It’s value goes up and down according to exchange rate and is also in a market, but it’s in a market that is hard to access, the Forex. To trade dollars (as in rising and lowering relative value) you need to be fluent in futures and options. It’s not a buy and hold proposition. In every futures trade there is a winner and a loser and that’s how you make your money. The other thing is you can lend dollars for interest, so it too is a debt instrument. Another class is gold, which is IMHO a form of money and is traded as a commodity so owning gold gives you some commodities exposure. I’m also long BTC which is similar to a commodity but it’s value lays in it’s volatility and the fact it can’t be manipulated easily. BTC behaves as a true market and has no value apart from humans and capitalism. You can’t make jewelry out of it for example. It’s feature is there are a limited number that will ever exist and so once that happens the market will be pure supply and demand and as that number is approached it’s becoming more supply and demand driven. BTC is world wide and not easily under government control and the transactions once transacted are immediate and permanent, so if banks freeze up or go out of business, BTC will still trade. If governments go out of business you can load it on a thumb drive and move. Each of these classes are all diversified with each other in a non correlated way, meaning when one drops the other’s price action is not affected. So if you loose stocks you don’t loose cash, so you spread the risk around.

      You can spread the risk around in an efficient way or an inefficient way and efficiency is defined as the most return for the least risk, which is what the efficient frontier and MPT describes. It’s like aerodynamics in a car. If the drag is less, there is less wasted energy. In some cases you may want concentration like owning a lot of equities, but concentrating equities concentrates your risk as well. If the world is humming along with no problems on the horizon equities work, but in the face of problems they fail and fail big. So that’s the dilemma. Index funds especially equity index funds offer a false sense of security. The 500 stocks in the S&P is diversified as opposed to a single stock, but if the county rolls over all 500 roll over so the “security” moves from the micro (single stock) to the macro view. The macro view world wide is shit, so unless you know how to trade the euro – dollar fx contract your best bet is to spread the risk around, hope to God you don’t loose your job and purchase the biggest portfolio you can afford.

      I don’t have a real opinion on owning sub categories of larger asset classes, like owning SV tilt, EM, Global momentum in the equity space. When the crash comes all correlations in a class goes to 1 and they all head into the dirt. some harder than others. Same with Bonds. EDV in this negative interest rate environment has the greatest chance to pay off IMHO so I own that as an offset to equity risk, but I won intermediate and cash and a tiny bit of foreign too. Part of the reason I bought EDV is because interest can go negative, and since I bought in when they were positive the value should go up and up the more negative 30 years go. They are in a IRA so I can sell hem high with no tax consequence and go short duration if I loose confidence in the trade. I have a set bond allocation as a class, but not a set allocation within the class. TIPS are inflation protected but I’m not sure they are deflation protected.

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