Diversification Can Work, If Correlations Are NOT High
Followers Of Jae’s Corner Were Alerted
You have seen the thumbnail below before, it referred to Q1 2021. By the way, equities today are almost entirely unchanged from that point in time.
Now ask: was the risk worth it? And it is worse, not better, because now, you don’t need to take extra risk (stocks) in order to get a reasonable return (2-Yr US Treasury = 3.9%). One reason that the correlations are lower is that others have taken note that if you don’t need to take the risk and get a very similar return, then re-setting a portfolio was very much in order. Voila. 60/40 outperforming.
The problem now is that this realization may effectively cap the returns of the riskiest assets. Why? Because huge portfolios have the ability to observe this, and act accordingly. If that means that the percentage allocated to equities is therefore impacted, then that means there is no threat of a new buyer, which is necessary in order for higher prices. You need the threat of a new buyer (or new chaser) in order to push prices higher.
Keeping Up With The Joneses
Have you seen this dynamic in real life? Of course you have: keeping up with the Joneses is almost exactly the same thing. If you think that there is another buyer, then what do you do? You buy the house first, and now, all the neighboring houses appreciate.
Oh by the way, this is the video which displays the exact same idea.
Is It Fixed For Good Now?
Maybe. Certainly, the banking sector problems are, perversely, helping. Why? Because now when there is a banking sector scare (not over, obviously), then money goes to safe havens, US Treasuries. And that has created a negative correlation, as seen in the first image.
The reason that the past two years have been so difficult? Moving correlations, which I have called the “glue.”
Takeaways
You can frequently read “diversification important.” However, this alone skips vital steps. The question is: did you? Did your broker?
Here, unfortunately, is the reality: Numeratorville is not designed to understand, or communicate this setup, used by the largest global portfolios. Numeratorville is designed to talk about individual companies, like Jae’s Rib Shack. Do the earnings projections for Jae’s Rib Shack, the single company, matter?
Glamorous and attention-getting? Yes. Relevant in the big picture (yours)? Nah.