Is It Too Late To Diversify?

As we look at the equity markets unwind and at investors’ reaction to the carnage, I see two lines of thought surfacing:

Some believe that COVID-19 is “the pin that came along to pop a debt and asset bubble of historic proportions.” 

Others believe that “the biggest profits are made by taking the opposite side of the most extreme overreactions,” and that now is the time to “capitalize upon numerous compelling buying opportunities.”

Both views above could ultimately prove to be right. The global economy had been showing meaningful signs of distress since 2018, and the virus outbreak served as a very firm shove to throw the markets off balance very quickly. 

The global recession and asset price deflation that have been avoided by monetary and fiscal easing for the past few years may now be inevitable. 

This is why I want regular, small recessions. They are stress tests for the economy to see which ones are resilient and which ones are zombie corps.

This recession has been delayed for a long time. It will be a disaster.

Based on what we’re seeing today, especially as the US government steps up its economic response by contemplating nearly $1trillion in fiscal stimulus, we can absolutely expect the economies of the world to hollow-out and become more unstable. 

Just this week, we’ve seen the response in the form of direct stimulus checks (helicopter money), a zero-interest rate, and a 90-day extension on paying taxes.

You know the world is on fire when the coronavirus has turned fiscal conservatives into socialists.

In conclusion: The Dollar about to be worthless.

Thank you for coming to my Ted Talk. 

In all seriousness, none of these measures are about the market anymore. It’s about survival.

And that’s what we should focus on first, as well. But how do we survive? Do we prepare for a vicious bear market or for a recovery?

Ultimately, that coin-flip does you no good when your focus should be on capital preservation.

The problem that I have with either (1) hunkering down for a long-lasting correction or (2) buying battered shares on the dip now is that one of the approaches is likely to be proven wrong. And remember, not making a choice is still making a choice.

Regardless, I’m not a big fan of relying on a coin toss to determine the success of my investment strategy.

Regarding plan (1), think about the bears who have been calling for a more severe market correction since 2013 or so, when the S&P 500 reclaimed pre-recession levels after an impressive, multi-year run. Being out of the markets due to fear tends to be a losing proposition over the long haul.

When it comes to (2), I fear that properly timing the market in the middle of a tailspin is a very risky proposition. The potential benefits of trying to catch the falling knife, in my view, do not justify the heartburn and insomnia that’s likely to accompany the implementation of the strategy.

So, instead of trying to call this one early, we can instead take the middle-road. In a sense, the only winning move is not to play, or at least to expose yourself broadly. 

I continue to believe that the best strategy in the current market environment is to diversify broadly across asset classes that tend to be only loosely correlated with each other. 

Here’s an idea of what such a diversified portfolio might look like, although other approaches could be used as well. As a recap, my proposed allocation is as follows:

10% in Direxion Daily S&P500 Bull 3X ETF (SPXL), in an attempt to gain 30% passive exposure to the S&P 500.

20% in Utilities Select Sector SPDR Fund (XLU) that offers an enticing 3.0% dividend yield and whose performance should remain only marginally correlated with the returns produced by the broad stock market.

20% in iShares 20+ Year Treasury Bond ETF (TLT), possibly the best complement to the S&P 500, despite the historically low yields. Part of this position could be directed to an inflation-protected Treasury ETF, such as the PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund (LTPZ).

40% in iShares 7-10 Year Treasury Bond ETF (IEF) for a bit of maturity diversification within the Treasuries asset class.

10% in SPDR Gold Shares (GLD) for some needed exposure to another “flight to safety” instrument.

By taking the balanced stance above, I believe investors can do relatively well in virtually any market environment:

If stocks continue to unwind and the economy goes into a long-overdue recession, 70% of the portfolio should be fine (i.e. treasuries and gold positions). 

If stocks rebound sharply, 50% of the portfolio should head higher (i.e. leveraged S&P 500 and utilities sector). 

If inflation rises, gold and stocks could benefit. 

If inflation drops, Treasuries should outperform.

Notably, I’m absent from crypto in this portfolio due to the dangers of short-term volatility — this portfolio solely focuses on capital preservation. As we covered yesterday, your portfolio can make use of long-term volatility assets, but it’s a complicated move. 

When we start to see stabilization in the market, that will be a much better time to allocate back into crypto and roll the dice. 

“But wait!”, someone yells from the back of the room. “Isn’t it too late to diversify?!”

Yes. It is. Diversification would have made a lot more sense in mid-February. But investors cannot unwind the clock now.

Given the uncertainties in the market, I believe there’s still no better approach to investing today than to be prepared for whatever comes our way. Being out of stocks completely does not make sense to me — holding off aggressively allocating to equities until the markets show clearer signs of stabilization has better promise.

Of course, I’d love to give you a concrete answer on what to do when markets are volatile. But in reality, it depends on many personal factors, including age, risk tolerance, personality, portfolio construction, current investment, large planned purchases, family structure, health, and so on and so forth. 

Periods of choppy markets and downturns have happened before, they’re happening right now, and they will happen again.  

As investors, and especially in times of calmer markets, we often look at historical market performance from a 10,000-foot view, hanging our hats on reassuring facts and statistics like this one: 

“The average annual return for the S&P 500 since its inception in 1928 through 2017 is approximately 10%.”

See? History is on our side. The facts are on our side.  We invest our money today, and in 10 years we can reasonably expect – though history is no predictor of the future – to earn somewhere around 159.4% in returns (with compounding). 

Simple, right? 

If that’s the case, though, why don’t we all just do that? 

Because reality sets in. It’s difficult to check emotions at the door. The markets aren’t on a direct path: they go up, and they go down, and downturns occur more wildly and more often than we tend to see from that 10,000-foot view. Just take a look at the magnitude and frequency of downturns in the table below:

The point is, market downturns happen to all of us — often more than once in our lifetimes — and it’s important to be prepared, knowing markets don’t just move upward in a linear fashion.

So when you look at your portfolio returns and see a negative number, don’t immediately rush to panic. As the New York Times noted*:

“Humility and patience are more helpful than panicky moves to time the market.”