Warren Buffett has two rules for investing:
Rule 1: Don’t Lose Money
Rule 2: Never Forget Rule #1
I like those rules.
I mentioned several posts ago that I used protective put options against all the stocks in my portfolio and broached upon the subject of diversification. But that really begs the question: “What is diversification?”
By definition, diversification is a technique of reducing risk by investing in assets that have poor correlation so that when one investment declines, the other declines less and will decrease overall risk.
The other method of reducing risk is by hedging which is what protective puts are doing for me. Hedging techniques work to reduce risk since the assets have negative correlation. When my stocks decline in value, my put options will actually increase in value.
A general tenet of investing is that increased risk should lead to increased returns. Therefore, one can conclude that by reducing risk, both diversification and hedging will decrease the overall return of a portfolio.
However, one must remember that it is more often avoiding large losses that leads to investment success rather than getting large outsized gains, just like too many unforced errors in tennis or turnovers in football lead to poor outcomes.
Correlation of Assets
One of the basic tenets of modern portfolio theory is the correlation between different asset classes. The goal is to maximize overall return of the portfolio while minimizing risk through asset allocation. When one portion of an investor’s holdings decreases, another portion will increase. The actual mix of asset classes becomes more important than any one individual asset selected.
One of the best sites that I ran across while doing some research for this post is a correlation matrix. There is no good way to reproduce it which is why I provided the link. It shows the correlation between different asset classes as represented by the three month return of the exchange traded funds representing the asset classes.
As you can see over the past three months, inflation-protected Treasuries (TIP) and gold (GLD) have been positively correlated. This makes sense since gold is typically thought of as a hedge against inflation. You can see that stocks whether large cap or small cap or international stocks have been positively correlated.
One has to remember that there are times when historical correlations deviate from the norm such that asset classes that may not have been very correlated move in tandem.
If we look to 2008 as a recent example of market instability, we can see that many asset classes lost significant value. However, I would point out that there was a major difference between returns on bonds other than high-yield and stocks.
Despite commodities in general losing money, gold had a positive return. So even though correlation values may have changed during that time frame, the general trend remained intact such that TIPs lost very little and were negatively correlated to equities.
I would like to leave you with one final link. It is a great article that discusses asset allocation, having a healthy investment mindset, and the importance of time in investing. I think this is one of the major takeaways that all investors should get from this discussion. Invest early and invest consistently through good times and bad.
If you can remember that, you can’t help but make money.
With the debate on the debt ceiling dragging into the eleventh hour and the prospect of a downgrade on the creditworthiness of the United States, I have been reading much speculation on the impact to the economy and stock market. It seems like another recession and crisis is almost guaranteed at this point. Speculation is that the stock market could take as much as a 50% tumble from current levels. So are you ready for stock market limbo (as in the dance when the point is to get as low as possible)?
As I read some of the speculation, I can’t help but think back to 2008 when the stock market lost 38% and some of the individuals I know lost that and more of their retirement accounts. I lost 18% in my retirement account because I held put options on every stock that I own. So I decided to check my retirement accounts and calculate my maximum exposure to a market drop of 50%.
Are You Diversified?
I admit that I occasionally watch Jim Cramer’s Mad Money show on CNBC although it has been a while. He has a segment on the show where callers can give him their 5 largest stock holdings with the question, “Am I diversified?” He will take a few seconds and then briefly outline his rationale explaining whether or not the caller is diversified. Usually this is based upon the business each company is in, and Cramer is making sure the investor doesn’t have 2 financial stocks or 2 retailers.
But did diversification really do anything in 2008? Even many of the big mutual funds lost a large chunk of change. The S&P 500 lost 38% despite being an index which is diversification by definition.
The whole point of diversification is to protect one’s portfolio from major losses. There are different methods of doing this not only within an asset class, but also between asset classes. One of the latest trends in personal finance is to get the right asset allocation. This is a topic for another post so I will save it for later. Suffice it to say, that if the point of diversification is to prevent losses, then you had better make sure that losses are prevented.
How Can I Sleep at Night?
Starting in 2007, I decided to purchase protective puts on every stock I owned. I had seen the bursting of the tech bubble and had experienced my share of losses on stocks over the years. I came to the conclusion that my number one priority should be to prevent major losses. After all, a 50% loss requires a 100% gain to get back to even.
Given all the recent talk about the different possibilities for loss in the market, I decided to check my retirement account exposure. Currently, I am 89.5% invested in stocks with the remainder in cash. I assumed that all of my stocks dropped to zero and wanted to figure out how much of my portfolio would be left. Essentially, I am calculating my “worst case scenario”.
The result: a 10.8% loss! I can live with that and even sleep well at night. Not to mention the fact that only about half of my retirement plan is based upon equities. I have about the same amount invested in real estate that when paid off will form the primary source of my retirement income until I am forced to take distributions.
So, are you prepared for a stock market swoon or crash? As Cramer might say, “Are you diversified?”