Are You Really Diversified? It’s A Great Moment For Finding The Answer

Are you really diversified? The present year is a great moment for finding out. To be completely honest, for about a year I have looked at my portfolio almost daily to be sure I have made sufficient provisions for every environment I can conceive. What makes the current moment interesting and challenging is the range of extreme events which may be improbable, but are not impossible within the next few years. Underlying all such discussions is the question of what investments are for. The short answer for most people is a combination of income and maintaining the long term purchasing power of your savings. It is not, in other words, a competitive game attempting to beat the market.

There are two ways to organize your thinking on this subject. You can either attempt to list the economic conditions you wish to diversify against or you can start by listing the asset classes you have available, sorting them in some sort of order of importance. For me the latter is the way to go because it is actually the way we all put together our savings and investment strategies.

That being said, the order of importance among asset classes differs greatly among investors. Some start with stocks, some with bonds, and more than you might think start with cash. Some start with their own private businesses or a particular asset for which they have special insight and experience, real estate for example. Most, however, ultimately need to diversify to some degree away from the asset they are most comfortable with. My starting point is pretty conventional because I have much more experience with stocks than with any other asset class.

Stocks Are The Primary Risk Asset But Can They Provide Diversification?

Stocks are easy. You can own them through broadly diversified indexes or through somewhat more focused indexes favoring growth or value. I have written about these choices in recent articles. That's about as fancy as investors should go unless they are prepared to do a lot of study or already have a lot of experience. With individual stocks a little knowledge can be a dangerous thing. Since I have 65 years of experience, however, it's what I do. Here's what stocks can do for the primary goals of current income and retaining purchasing power:

• Stocks like consumer staples with products consumers must have (health care, utilities, and defense) do well in recessions and deflationary times. Two stocks I own for just this reason are Johnson & Johnson (JNJ) and McKesson (MCK). When something bad happens in the economy I ask what impact it will have on these two companies and the answer is None Whatsoever. Other companies I own for this reason are defense stock Raytheon (RTN) and P&C insurance company Travelers (TRV). A close look at my largest position, Berkshire Hathaway (BRK.A)(BRK.B), shows that its three major operating units (insurance, utilities, and BNSF railroad) plus the staples in its stock portfolio provide good defense at times when the economy is weak.
• Equities as an asset class often do reasonably well keeping up with inflation. Stocks kept up with the German hyper inflation of the early 1920s. They did less well in the US 1970s as measured by stock prices, but operating results and dividends continued to grow. The loss was all about declining valuation which for the investor who could wait it out left stocks coiled for the generational bull market which began in 1982.
• For direct inflation protection consider energy. Inflation almost always involves increasing energy prices. In the current price inflation, energy companies have been cautious about ramping up exploration and production. The one I own is Occidental (OXY).
• The short answer on stocks and diversification: don't just settle for scattershot diversification. Give some thought to what kinds of stock help protect in different scenarios.

Do Bonds Actually Diversify?

Looking backward four decades, many responsible investment firms have touted the famous 60-40 stock/bond portfolio with the bond portion starting smaller and ramping up as the equity portfolio shrinks to 100 minus your age. Does this actually work? Is it reasonable to stop here and consider yourself diversified? My answer to both questions is no.

Over my entire lifetime as an investor, bonds have not diversified in any helpful way. I use the term “helpful” because bonds actually were a persistent drag on a stock/bond portfolio from the 1949 bull market through the inflationary 1970s until 1982. From 1949 until 1970 the low but rising yield of bonds were actually a drag on the great post-WWII bull market. From 1970 through 1982, as rising rates crushed bond prices, bonds were pure poison and came to be called “certificates of confiscation” which provided “return-free risk.” Even stocks, though down in price, provided dividends and a future in which they would bounce back.

Bonds also didn't diversify in the long bull market from 1982 to 2000. Despite minor periods when one asset class did better than the other, stocks and bonds tracked closely with stocks doing slightly better. This has also been largely true for the two decades which followed as rates fell after the financial crisis of 2007-2009, after which bonds were mostly stable and stocks rallied strongly. So much for bonds? Not quite.

The one extended period in which bonds provided helpful diversifications was the Great Depression. Taken as a whole, and especially for its first three years, the Depression was a period of outright deflation. Stocks were a disaster and corporate/junk bonds were almost as bad with many defaults. Stocks ended the decade about 60% below their 1929 high and did not fully recover until 1954. Meanwhile safe US Treasury bonds were stellar yielding 6.04% for the decade, this in a period when every dollar could purchase more goods. Here are the deflation numbers for the first three years:

• 1930: -6.4%
• 1931: -9.3%
• 1932: -10.3%

The three deflationary declines in the value of a dollar meant that you could buy what had been a dollar's worth of goods or services in 1929 for about 76 cents. After that, outright deflation subsided, but small price increases never made a dent in the change. As a result, the 6.04% nominal return on US Treasuries was around twice that in real terms.

You can't get that return on Treasuries right now, although it may become possible if the Fed raises rates as promised. A period like the 1930s seems improbable, but it also seemed improbable in 1929. I would wait a bit on bonds, however, as cash would perform about as well at the moment with less risk. When it's time for bonds again, if it ever is, remember: don't reach for yield, stick to US Treasuries.

Real Property, Productive Real Assets

By real property I mean real property. I don't mean REITs. REITS are securities. REITs are not real property you can put your hands on. I traded them once, six or seven years ago, when they overreacted to a risk of Fed rate increases. In the past they have not diversified. In 2007 they were down 17.9% and in 2008 they were down 42.3%, and as the market recovered in 2009 they were up almost exactly the same amount as the S&P 500 (SPY). Their fifteen-year return has been 7.7%, almost 3% annualized below the 10.66% of the SPY. They seem to do best in years when yield is a major issue, but I send this link for those who want to look at sector performances in detail.

What I'm suggesting as a diversifier is real property such as rental properties, farmland or timberland. I'm well aware this takes some work but also know people in the rental property business going back a couple of decades and their income and property appreciation did well even through the financial crisis. Otherwise, your best real property may be your own home, which won't go up or down a lot and will provide income in the sense that it saves you from paying rent.

Capital intensive businesses may do well as the replacement cost of their factories goes up. One more note on productive real assets. During the German hyper inflation of the early 1920s the biggest winners were owners of productive land and industrialists like the Krupp family who owned factories and factory equipment. They were so successful that it led to huge economic inequality which eventually led to Hitler.

I Bonds And TIPS

I Bonds are a wonderful vehicle because they have features which defend against both inflation and deflation. I won't try to explain here but refer you to what I wrote here and here. TIPS (Treasury Inflation Protected Securities) don't have as many positive features as I Bonds, but if the rates on straight Treasuries keep climbing they will at least present a positive real return including inflation protection. Google both I Bond and TIPS and read up on them.

Social Security And Pensions

The late John Bogle, founder of Vanguard, suggested that in putting together a portfolio you could think of Social Security as a phantom bond. I agree entirely. An annuitized asset like Social Security or my defined benefit State of Illinois pension really does provide the major income function of a bond and in both cases the date of maturity is unimportant to me because it will coincide with my own death. Most individuals I knew at UIC took a passive approach to their State University Retirement System pension and many feel the same way about Social Security. My own approach was far from passive.

My choice with Social Security was simple. I waited as late as possible to start receiving it and as a result got the 8% annualized increase over four years, 32% in all, which would be the increase in every payment received for the rest of my life. I recommend this approach to most people who are in good health. Those who live to the age of 83 have won the game.

With my university pension I first did careful research on the terms and probability of actually receiving it (this was Illinois) and concluded that it was a safe bet. Then I chose to annuitize rather than taking a lump sum. I had enough assets to manage and it was helpful to have a basically safe income stream that others had to work out how to manage. It also helped that in a fit of madness the organizers of the pension system in 1979, a moment when inflation was high, tacked on a 3% annual compounding inflation adjustment. I then bought my years of military service and one year as a high school teacher. Those were among the best investments I have ever made.

To the best of my ability, I gamed the system, clustering a number of special income sources into my final four years. The State University Retirement System in Illinois has caught on and closed most of those loopholes and defined benefit pensions are increasingly rare. If you are lucky to have one, you should think carefully about the minutiae to make the most of it.

Stuff And Things

Stuff and things are measured against money. One way to diversify is to buy stuff and things when they look like a good deal. You can convert your money into durable stuff and things at any point and think of it as an inventory which is measured against the cash that buys them.

Does Bitcoin Diversify?

It's hard to see how Bitcoin and other crypto currencies do much to protect and diversify. In the present market Bitcoin has moved in the same direction as the stock market suggesting that it is just another risk asset. Its main virtue is that it isn't heavy and hard to carry like gold. Its weightlessness, however, comes with a burden that matches that of gold and does little for its convenience as a store of value.

Your Health

Is health an asset class? If nothing else it marks a great divide between those who have it and those who do not. Like other asset classes it has a significant element of chance, but not as much as many fatalists think. Major illnesses which weaken human beings and make them vulnerable to shortened healthspan and lifespan can be prevented or made more manageable by individual actions. Diabetes, heart disease, and many cancers can be addressed by disciplined avoidance of smoking and alcohol consumption, exercise, better sleep, better food choices, and, yes, money. Capital invested in good health pays huge dividends in times of economic crisis and other afflictions such as pandemics.

An improved diet costs a bit both in money and involves an investment of time in learning what foods you should eat. It also takes will power. Exercise is the same. Nobody especially likes daily workouts with weights, resistance bands, or aerobics but they do two important things. One, exercise lengthens your life and improves its quality. Two, fitness improves your ability to deal with whatever comes up whether in the economy or very occasionally in the need to defend yourself against an actual physical threat. Pull your socks up and make this investment.

Can You Diversify Against Black Swans?

Barton Biggs, a thoroughly buttoned down Yale graduate but also a Marine as well as the founder of Morgan Stanley Investment Management, left a book written in his final years entitled Wealth War & Wisdom (2008). The major theme was the problem presented by Black Swans, rare but extremely destructive events like wars, revolutions, and plagues which appear without warning and devastate complacent populations. In normal times Biggs was a stock guy, recommending portfolios with 75% equities, but he recommended devoting serious thought and some resources to abnormal times, perhaps as much of 5% of assets. Here's what he wrote in the conclusion of his book:

By definition the next Black Swan will be some form of total breakdown of civilized society and the social and financial infrastructure as we know it… The trigger event could be a massive terrorist or nuclear event that disrupts the economy for months and maybe for years… Or it could be a plague, a massive SARS epidemic, in which hundreds of millions die, or an electronic explosion that cascades into a complete breakdown of the world's financial accounting systems. Whatever happens, it most likely will be an event that is both unexpected and we will not be prepared for…”

He favored farmland on which it is possible to grow food. It should be close enough to get to, but remote enough to be inaccessible to dispossessed hordes. He reminds that air travel will be one of the first things to go. In some ways the recent pandemic was a weak version of this scenario. He adds:

Your safe haven must be self-sufficient and capable of growing some kind of food. It should be well stocked with seed, fertilizer, canned food, wine, medicine, clothes, etc… Even in America and Europe there could be moments of riot and rebellion when law and order temporarily and completely breaks down. A few rounds over the approaching brigands' heads would probably be a compelling persuader that there are easier farms to pillage.”

This sounds a bit like a crazy survivalist or the bomb shelter builders of the 1950s, but you should remember who Barton Biggs was – a financial guy who founded a hedge fund and whose background juxtaposed a private club at Yale with the US Marines. Very few people could or would follow these suggestions literally. Parts that stand out as universal are the fact that Black Swan events arrive without warning, it helps to be prepared, and the fact that in many such crisis events the essential task is to survive a brief period of chaos and possible lawlessness. The key concept is self sufficiency and the readiness to take necessary action without looking for outside help.

Black Swans are unlikely to happen and perhaps not worth an enormous investment for ordinary people. Such events are possible, however, and it is worth stopping occasionally to think about what you might do to prepare. I haven't yet built a block house stocked with food and rifles on my 40 acres of family timberland. It's probably too far to get to in a crisis anyway. My personal redoubt is just my suburban home. I stocked the freezer with staples at the beginning of the pandemic until my wife threw a fit and insisted that we eat the stuff immediately. As a Vietnam vet I have a weapon, but haven't fired a weapon of any kind since December 1966. My shotgun is probably just for peace of mind but my house would be a terrible choice for a burglar. Unlike Barton Biggs, a peacetime Marine, I don't fire warning shots.

Conclusion

The problems one should diversify against start with inflation, deflation, recession, depression, and some combinations of the above. The tools for dealing with them are primarily the major asset classes: stocks, bonds, and real property. I Bonds are easy and defend against both inflation and deflation, but you can only buy $10,000 per Social Security number annually plus Gift bonds. TIPS may soon be priced as a reasonable inflation hedge. Investment in your personal health may be my most important suggestion for many people It provides a huge payoff to time, effort, and a little care in eating the best diet. As you get older you realize it's worth a lot to get out of bed every morning feeling well.