Does Diversification Still Work?

Back when I was in university, I remember pulling an all-nighter to study for a final exam. My roommate was doing the same thing, cramming to study for his own exam. We were two stressed-out students back then.

That night, my roommate said his stomach hurt. Me, being the cynical person that I am, didn’t believe him. I thought he was fishing for an extension on his exam date.

Turns out, my roommate wasn’t acting. He had acute appendicitis. He went to the hospital later that night and had an emergency appendectomy.

Boy was I wrong.

Today, that old roommate is still a good friend of mine. He’s truly a terrific person. And every time I see him, I apologize for that night. (Again, sorry buddy.)

As far as medical procedures go, the appendectomy is very effective. It has a success rate of over 95% with a low mortality rate. It’s the gold standard treatment for appendicitis.

What does this have to do with investing?

The investing world has some gold standards, too. Diversification is one of them. It’s the rule of not putting all your eggs in one basket.

However, 2022 was the year diversification didn’t work. It was a terrible year where almost every investment (stocks, bonds, real estate, etc.) went down at the same time. It’s the year when all the eggs in all your baskets broke.

So you might be wondering: Does diversification still work?

Back to appendectomies for a moment: When I was reading about this medical procedure, I came across a few studies that challenged it as the gold standard. For example, one study looked at using drugs versus doing invasive operations. All the papers I saw had the same conclusion: an appendectomy is the best choice to treat appendicitis.

Here’s my point.

There’s a big difference between a profession like medicine and the investment world. In medicine, doctors build on past successes and failures. There’s a constant improvement in medical knowledge, which benefits us all. It’s the reason why life expectancy has steadily increased over the past 100 years.

The investment world is very different. It features emotional humans operating in the volatile economy. This combination of emotion and volatility makes for a tough learning environment. That’s why it’s so hard to learn (and stick to) the basics of good money management.

I can’t imagine a doctor ever saying, “The last appendectomy we did was a failure. Let’s go back to using opium and leeches.”

But in the investment industry, people say crazy stuff all the time. That creates doubt, which makes some people question their long-term investment plans. So you always need to be on guard.

Morgan Housel, a partner at Collaborative Fund Management, also made this distinction in a recent article. He said “I can imagine a world in 50 years where things like cancer and heart disease are either non-existent or effectively controlled. I cannot ever imagine a world where economic volatility is tamed and people stop making financial decisions they eventually regret.”

Last year was a bad one for investing. But you need to tune-out the folks who say the system is broken. If anything, our financial system is starting to get back to normal.

So is diversification broken? Let’s take a closer look.

1) It’s Rare for Stocks and Bonds to Fall in the Same Year

A well diversified portfolio holds a combination of stocks and bonds. Stocks are added for growth, bonds are added for income.

With stocks, you are a business owner. That means you’re entitled to profits and future growth. Of course profits and growth are not guaranteed. So stock prices can be volatile in the short-term.

With bonds, you are a business lender. That means you earn interest from lending out your money. Most companies that issue bonds have good credit scores and pledge collateral. So bond prices tend to be less volatile compared to stocks.

Having both stocks and bonds in a portfolio is good because it reduces overall risk. When stocks fall, bonds normally do well because people rush to the relative safety of fixed income. But 2022 was not a normal year.

Last year, central banks aggressively increased interest rates to fight inflation. That, along with a slowdown in China, and a war between Russia and Ukraine, made it a bad year for stocks.

Bonds had a terrible year, too. Most bonds started 2022 with extremely low yields. When interest rates started to rise, bond prices fell dramatically (bond yields and prices move in opposite directions).

However, it’s rare for stocks and bonds to go down at the same time. The last time stocks and bonds were negative in the same year was more than 50 years ago in 1969.

In fact, stocks and bonds being negative in the same year has only happened three times since 1928. That means a diversified portfolio of stocks and bonds has reduced risk over 95% of the time.

There are no 100% guarantees in the market (or medicine for that matter). But with a 95% success rate, diversification is still the gold standard in my book.

_{Source: RBC GAM. As of December 2022. Bonds represented by U.S. 10-Year Treasury, stocks represented by S&P 500 Total Return Index (USD).}

2) Still Protects Against Taking On Too Much Risk

A couple of years ago, I spoke to an individual who had most of their retirement savings invested in two stocks: Facebook and Google. Not my definition of good diversification.

Sure, technology stocks were the big winners in the 2010s. Companies like Apple, Amazon, Facebook and Google grew to become some of the biggest companies on the planet. But stock prices can only go so high before gravity kicks in.

Technology companies were hit hard in 2022. For example, Facebook had a peak to trough drawdown of minus 76%. Drawdowns like that are the reason why proper diversification is so important.

 

 

A diversified portfolio reduces the damage from the worst hit sectors in the stock market. It’s still the best way to protect investors from taking on too much risk. After all, nothing works forever.

I don’t know how that individual with the Facebook/Google portfolio made out. But I do know that a portfolio of only two stocks is way too risky for most investors.

3) Getting back to normal

Everyone today talks about the “new normal” (i.e. how the world has changed after COVID). But the financial markets are returning to the “old normal.” And that’s a good thing.

As painful as it was, 2022 was a year of normalization. Artificially low interest rates were used to support the economy during COVID. But those ultra low rates created several distortions in the market. Today, interest rates are starting to normalize, and those distortions are being corrected.

For example, ultra low rates penalized people saving for retirement. Investments like bonds and GICs made almost no money during the pandemic years. Today, with more sustainable interest rates, fixed income investments are now expected to earn a fair return.

Ultra low interest rates also distorted the real estate market. A real estate bubble formed in many markets in early 2022. Bidding wars for homes were common. Now, interest rates are starting to normalize, and home prices are coming back to reality.

Higher interest rates have also flushed out the worst excesses in the market. Trading in meme-stocks, NFTs and crypto currencies is down dramatically (in my opinion, that stuff was always “gambling” not “investing”). Today, investors are once again focusing on what’s most important: profits.

Conclusion

2022 was the year when diversification didn’t work, but I still consider it the gold standard for investing. Rising interest rates impacted both stocks and bonds last year, which is rare. But higher rates were necessary to correct some distortions in the market.

As painful as it was, 2022 was a step toward more sustainable future returns.

_{This information has been prepared by Paul Carvalho who is an Investment Fund Advisor for Investia Financial Services Inc., and does not necessarily reflect the opinion of Investia. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Fund Advisor can open accounts only in the provinces in which they are registered.}