What is Diversification 2.0?

Diversification is the first rule for any long-term investor. The idea is simple: spread your money across several investments. If one fails, the others will be there to pick up the slack. Diversification makes sense in any market. It is the time-tested strategy that is as fundamental to investing as gravity is to the world of physics. However, something seems to be changing.

Diversification is disappearing, but why?

In a global economy more assets are correlated. As more countries and businesses become reliant on one another more assets are moving in lockstep with one another.

Consider research which uncovered “a rise of cross-asset correlation between select asset classes.” The research reflects “an average correlation increase of 33% between the test periods 1990-2000 and 2006-2016.” This heightened correlation is a problem because, “a significant market event or correction can be compounded by a period of highly correlated assets across integrated financial markets.”

A significant market event is looking more possible than ever given the heightened level of the inflation-adjusted price-to-earnings ratio (CAPE ratio). Today, this figure is higher than it has been at almost every point since 1880. An elevated CAPE suggests that stocks are overvalued. Previously, a high CAPE has preceded market crashes. This risk appears worrying in a highly correlated market.

This new characteristic of investing in today’s markets has led some to question ideas about traditional portfolio construction. It seems that simply diversifying across different companies is not enough. Effective investors must diversify across asset classes. The new question, however, is “how much do I allocate towards other assets, like gold, to ensure a balanced approach?”

Here, research offers some answers. Data from State Street in cooperation with the World Gold Council has determined that “gold has had low or negative correlation with major equity indices since 2000.” Additionally, their research shows that gold also has a low, or negative correlation to major bond indices.

The data also shows that gold has delivered positive returns during nine of eleven “black swan” events such as “Black Monday,” the 2008 financial crisis, the subprime meltdown, and the flash crash of 2010. Gold has also delivered positive returns in periods of both low, and high inflation, though does best during periods of high inflation.

Their work is a clear indicator that gold plays a crucial role in the formation of any portfolio that is designed to withstand the inevitable rise and fall of equity, and fixed income markets.

So, what is the right portion of gold to hold in a portfolio?

The same body of research suggests that holding anywhere from 2%, 5%, or 10% can improve the Sharpe ratio of the portfolio. The Sharpe ratio is a measurement that enables investors to gauge the risk/return balance of a given investment. Therefore, by holding more gold, investors can improve the risk profile of their total investment strategy.

True diversification today means something different than it did in the past. Investors need to cast a wider net to safeguard themselves against an increasingly correlated market.

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