Posted by on Feb 11, 2013 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  Feb. 8, 2013 4:22 p.m. ET

If you care about risk, not just return, you could be forgiven for just wanting to bury your money in your backyard.

With bond prices near all-time highs and yields near record lows, the returns on many bonds are doomed to be negative after inflation. Since 2000, the U.S. stock market has fallen by more than 40% from top to bottom — twice — but still looks overvalued by some measures. Real-estate investment trusts are at their highest prices in five years. Gold has sextupled in price since 2000.

The past decade also has shown that traditional diversification — parceling out your money across U.S. and international stocks and bonds, along with a variety of other assets — can leave investors exposed to the risk of severe losses.

Thinking about diversification in a different way — what we might call “differsification” — might change your views entirely. Instead of spreading your bets to protect against a plunge in the U.S. stock market, you should regard your portfolio as a set of bets on basic economic conditions and create one bucket for each: expansion, recession, inflation and deflation.

How does this approach differ from traditional diversification?

Financial planners have long built portfolios based on historical correlations, or the extent to which various investments have moved up and down together in the past. The theory is that when stocks zig, bonds and other investments will zag; market declines in one asset will be buffered by rising values for others.

Unfortunately, markets forget all about theory during a financial panic.

“You’d like different assets to move together when markets are doing well and then to deviate from each other when markets do badly,” says Mark Kritzman, chief executive of Windham Capital Management, an investment firm in Boston that oversees $1.3 billion. “But history shows you tend to get the exact opposite.”

In calm markets, Mr. Kritzman’s research shows, various investments tend to have sharply different returns. But in a financial crisis, almost everything crashes — exposing you to losses in lock step at the very moment when protecting against a collapse in U.S. stocks is most valuable.

Furthermore, past correlations don’t predict the future. For much of the 1980s and 1990s, U.S. Treasury bonds and U.S. stocks tended to move up and down in price together. During the 2008-2009 financial crisis, Treasury bonds were the only major asset that went up as U.S. stocks crashed. Next time, who knows?

Peter Joers, co-founder of Greenline Partners, an investment-advisory and consulting firm in New York, has a twist on diversifying. All financial assets, he points out, respond predictably to changes in the “basic drivers” of growth and inflation.

Viewed this way, the challenge you face isn’t figuring out which assets are cheap today. It’s building a portfolio that can prosper regardless of whether economic growth is high or low or whether prices are rising or falling.

By spreading your money across mental buckets customized for each scenario, you give up the hope of striking it rich with a few great calls about how the future will unfold. But you get what Mr. Joers calls “dependable diversification.” You also can “see your bets more clearly,” he says.

In your “expansion” bucket, for the scenario in which the economy grows faster than forecast, you want stocks, real estate and, if you can tolerate their risk, commodities. In your recession bucket, for times when economic growth falters, you want bonds. The inflation bucket, for periods when the cost of living rises faster than expected, holds Treasury inflation-protected securities, or TIPS, and, if you can stand the volatility, commodities. Finally, in your deflation bucket, for times when prices are falling, you want stocks and conventional bonds like U.S. Treasurys.

Of course, prices can rise or fall as the economy grows, and a shrinking economy can experience either surprisingly high or low inflation—which is precisely why you need money in each bucket.

How does differsification work in practice? If you own no TIPS, your inflation bucket is perilously empty, and you need to fill it. Otherwise you are gambling that the cost of living won’t rise higher or faster than most people expect—and that is an expensive bet to get wrong.

Investors are predicting an inflation rate over the next 10 years of roughly 2.5% annually, says Gemma Wright-Casparius, manager of the Vanguard Inflation-Protected Securities Fund. If inflation runs higher than that, TIPS will guard you against a loss of your purchasing power. If it doesn’t, you could lose money on your TIPS — but your other buckets should do well.

Instead of constantly sloshing your money around, put some in each bucket and keep it there as lifelong insurance against everyone’s ignorance of the future. Play around the edges every once in a while, if you must. But sticking to basic differsification will give you peace of mind — and probably the last laugh.

Source: The Wall Street Journal,


Definition of DIVERSIFY in The Devil’s Financial Dictionary