Invest a few moments in thinking. It will pay good interest.

~ Author Unknown

We've been talking about bubbles all week. So far, we've outlined 5 financial bubbles and 5 socioeconomic bubbles that could affect your money and your quality of life. It looks like we may have a bubble of bubbles on our hands. Does that have to be a bad thing? How can we prepare for the popping of these bubbles? What does all of this mean for your investment strategy?

Traditional Advice

One perennial piece of advice is that diversification can smooth out fluctuations in your investment returns. Don't put all your eggs in one basket. That way, if you have 3 baskets and one is dropped or otherwise damaged, you'll still have the eggs in the other two.

There are a couple of “defensive” investment strategies that are often recommended for long term investors, especially during trying economic times:

  1. Invest in High Quality Dividend-Paying Stocks: The idea here is that you will “get paid to wait”. So if we hit an air pocket in the economy and the stock market, at least you'll be able to collect 1% – 5% in dividend income. The assumption here is that the value of these stocks will not fall as much during a bear market because they tend to be of higher quality. You should just wait it out because stocks always rebound eventually.
  2. Stick to Your Asset Allocation & Rebalancing Plan: This approach is often used by passive index investors. They simply choose a stock allocation and a bond allocation, and periodically rebalance by buying some of the asset class that has fallen and selling some of the one that has risen. The assumption here is that stocks and bonds are usually not highly correlated, so if stocks are going up, bonds are probably going down. This is how diversification is supposed to help you spread out your risk.

Why Diversification Will Be Less Effective in This Environment

So the idea of diversification is to spread your money among asset classes that are not highly correlated. In many cases, putting your eggs in different baskets may be a good strategy.But what if all 3 baskets fall off the truck at once? That can happen to your money too.

The strategies above would have worked pretty well during the secular bull market of 1982-2000. During that time period, stocks largely moved higher, and cyclical bear markets were buying opportunities. Many believe (myself included) that a secular bear market began in 2000. For that reason (and few others) the strategies mentioned above won't work as well, if at all. Danielle Park, money manager and author of Juggling Dynamite, recently offered some very good reasons why we need to sell to avoid losses. I've incorporated many of those here:

  • Contracting PE Multiples: One hallmark of a secular bear market is that price to earnings ratios tend to contract. That means that investors are willing to pay less for $1 of earnings. So even if your favourite dividend-paying company manages to maintain or increase its earnings, the stock price could still fall – perhaps by quite a bit. The same goes for the stock indices. A 3% dividend is cold comfort if your capital has depreciated by 40% or more.
  • Increasing Correlations Within Asset Classes: If stocks of various sectors, geographies, and capitalizations trade up or down together, the argument for diversification within asset classes falls apart pretty quickly. In fact, there has been a lot of noise made lately about how the stocks in the S&P 500 are now 81% correlated with the index. When everything trades in the same direction at once, diversification doesn't work. Another article asks What Is Correlation Telling Us? This one discusses the role of government backing of certain bonds and rates being held very low as factors that have lead to higher correlations among certain types of credit in the bond market.
  • Increasing Correlations Between Asset Classes: Historically, stocks are not highly correlated with bonds. In fact, they are usually inversely correlated. But since the middle of the 1980s, stock and bond prices have moved in the same direction – mostly up. We would normally expect that, as stocks rose from 1982 – 2000, bond yields would have risen too.(Remember that bond prices and yields move in opposite directions.) A chart comparing the 10 year U.S. treasury yield to the S&P 500 shows the opposite. In fact, bond yields fell as stocks rose. That means that bond prices rose in tandem with stock prices. That would have made a traditional rebalancing approach much less effective.
  • HFT (High Frequency Trading): Many large trading and investment firms now use computer algorithms to execute trades. A lot of these computer models are based on similar technical patterns, so the market can sometimes look like a herd of cattle stampeding in one direction and then the opposite one. We've definitely seen a lot more of that lately. (If you're interested in more particulars on the effects of HFT on markets, read this article on Correlations Among Asset Classes.)

I should say that recently, bond prices have actually been rising as investors have reverted to their traditional view of bonds as a safe haven in falling stock markets. My point was simply that hearing someone say that stocks and bonds always move in opposite directions and investing your money according to that historical precedent may not always be a great idea. You still need to look at each asset class individually. Where is it trading relative to its own unique cycle and relative to the overall economic cycle? Stock cycles tend to be shorter than bond cycles, so it's possible that the secular bull market in equities ended in 2000, but the bull market in bonds could keep going for a while longer.

The Dangers of History & Tradition

A lot of the investment guidance out there is based on historical precedent and clichés that may not be effective in the current market environment. That's not to say that there's no place for the tried and true. But there's no substitute for independent thinking and due diligence. (See Ignorance Makes You a Better Investor and Other Money Losing Fallacies.)

There are so many aspects of today's financial markets that are unprecedented, including the interference of governments and central banks, that it would be foolhardy not to at least review your investment approach. (See Today's Markets: Not Business as Usual.) Although it's less likely that all 3 of your baskets will fall off the truck at once, that doesn't mean it won't happen. And if the weather's bad and the truck driver is intoxicated, you might want to keep more cash instead of investing in so many eggs. 😉

If asset classes are becoming more highly correlated, and those in the economic driver's seat may need a driver's ed refresher, where can you put your money? On Monday, we'll take a look at the different asset classes and the pros and cons of putting money into each of them right now.

Do you think diversification will always provide better or safer returns?