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October 8, 2018

Diversification Comes at a Cost

One fear many investors have is incurring a large drop in the stock market. “Major drawdowns,” as defined by AQR Capital Management, are those where prices drop by at least 20% from peak to trough. The investment firm counts 11 such drops as having occurred in the stock market since 1926, or about one per decade.

Though stock prices have fully recovered within 27 months, on average, according to AQR’s data, realizing the recovery requires an investor to stay fully invested in stocks. This is something that’s much easier said than done. Various studies show a tendency to pull out of stocks when their prices are down. Even if someone sticks with their allocation to stocks, the drops can be painful. Major drawdowns can even be problematic from a timing standpoint, especially for those who had the unfortunate luck of reporting shortly before the drop occurred.

There is a simple solution for cushioning against the blow of such drops: diversify. Holding assets whose returns are affected by different risks than stocks lessens the impact drawdowns have on portfolio wealth. However, diversification can come at the cost of lower long-term returns, as an analysis from AQR shows.

Among the diversifiers looked at were 10-year U.S. government bonds (e.g., Treasuries). These are uncorrelated to stocks and have, on average, experienced positive returns during major drawdowns for stocks. A basket of commodities is comparatively more correlated to stocks than bonds but has historically had low correlations with stocks. Commodities do have higher long-term average returns than bonds, but with far longer tails. In other words, bonds offer better odds of cushioning the blow, while commodities offer greater average upside albeit with much larger upside and downside returns. (Expenses do not appear to have been factored into AQR’s data.)

Cash can also be used to diversify. Just moving 10% of the equity allocation into stocks has historically led to 2.8% better drawdown returns. While this may sound enticing, the trade-off is a 0.8% reduction in long-term returns. As is the case with bonds and commodities, the price of easing short-term pain is less long-term wealth.

What about other sources of protection? AQR looked at a few, the easiest to understand being gold and puts. Since 1986 (a short time period for this type of analysis), including an allocation to gold has led to positive returns during stock market drops of at least 10%, at the cost of lower average returns. Puts—options that allow the contract holder to sell at a preset price—have good defensive properties but lead to negative long-term returns. (Various factors affect the actual return of a put strategy, but AQR’s findings should serve as a warning sign in regard to continuously holding onto puts.)

As far as timing the market is concerned, it’s harder than it looks. AQR looked at the drawdowns relative to Yale professor Robert Shiller’s CAPE (cyclically adjusted price-earnings) ratio. They found no consistent patterns between the level of the long-term valuation indicator and when drawdowns occur. More so, stocks tended to continue to rise when the markets were “very expensive.” Such increases occurred “more than half of the time.” (To be fair, AQR is not completely opposed to making small tactical tilts based on valuation or momentum indicators but have suggested investors just “sin a little.”)

The only way to truly protect against stock market drops is to not be in the stock market. Hedges, such as puts, do pay off during drops, but the stock market rises far more than it falls; most calendar months have positive average monthly returns. Diversifying into uncorrelated assets, such as bonds, reduces the volatility of an all-stock portfolio, but at the cost of lower long-term returns.
The Week Ahead
Monday is Columbus Day, which is a federal holiday. As such, the bond markets will be closed. The U.S. stock exchanges will, however, operate on normal hours.
Third-quarter earnings season will begin in earnest with eight S&P 500 index companies scheduled to report. Included in this group are Dow Jones industrial components Walgreens Boots Alliance Inc. (WBA) and JPMorgan Chase & Co. (JPM), which will report on Thursday and Friday, respectively.
The week’s first economic report will be the September producer price index (PPI) released on Wednesday. Thursday will feature the September consumer price index (CPI). September import and export prices and the University of Michigan’s preliminary October consumer sentiment survey will be released on Friday.
Three Federal Reserve officials will make public appearances: Chicago president Charles Evans on Tuesday, Wednesday and Friday; New York president John Williams on Wednesday; and Atlanta president Raphael Bostic on Wednesday and Friday.
The Treasury Department will auction $36 billion of three-year notes on Wednesday, $23 billion of 10-year notes on Wednesday and $15 billion of 30-year bonds on Thursday.
Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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