Over the years, many advisors, pundits and investment managers have said that diversification is the only free lunch in investing.
As the saying goes, by spreading your investable funds out across many different asset classes, with low to negative correlations (in other words, when one assets tends to be up, the other tends to be down), an investor can reduce risk while realizing similar or a higher returns accounting for that risk.
We find that such blanket statements do more harm than good, since more often than not, the price that is being paid (i.e., the value you get) is ignored.
This has the potential to cause unanticipated volatility, which will offset the benefit of diversification. An astute investor must always be aware of valuations and should compare those valuations to the price of an investment opportunity to gauge the perceived benefit of that investment.
A Lesson from Japan
A perfect example of the challenges of diversification is the Japanese stock market since 1990.
Someone could have added Japanese equities to their portfolio with the thinking that they would add diversification to an equity portfolio that was heavily weighted to U.S. stocks. Unfortunately, if someone had invested money in the Japanese stock market at the start of 1990, they would still have a cumulative loss of more than 48% measured in U.S dollars. So much for the benefit of diversification.
Since July 2008, commodities have offered little diversification benefit versus traditional equities.
Are Commodities a Good Diversifier?
A more recent example is using commodities as a diversification tool. From September 2003 to July 2008, oil had a cumulative return of 434% (Source: Bloomberg). The narratives driving the price advances of oil and other commodities were very compelling, ranging from oil being a finite resource to emerging market growth being so strong that demand for commodities would grow to infinity. Unfortunately, right when investors were catching on to the “benefit” of using commodities to diversify, commodities were about to enter into a bear market. Since July 2008, commodities measured by the CRB (Commodity Research Bureau) Index have offered very little diversification benefit versus traditional equities when comparing the correlations between the two asset classes.
The Correlation Between Commodity and Equity Returns
Marco Lombardi and Francesco Ravazzolo of the Bank of International Settlements (BIS) recently published a paper titled “On the correlations between commodity and equity returns: implications for portfolio allocation.” This paper begins to address some of the misconceptions around commodities as a diversification and return enhancement tool in a portfolio.
When reading this research paper, I kept thinking about it in the context of valuations and the need to always remind oneself about the hazards of paying too much for an asset class whose price has already been bid up by a great growth story. Though a bit technical in places, I hope you find this paper thought provoking when thinking about the benefits of diversification and portfolio construction: “On the correlations between commodity and equity returns: implications for portfolio allocation.”