Diversification revisited
Arecent article in The Economist by Buttonwood asks the question: “Should you put all of your savings into stocks?” The piece is motivated by the recent surge in the US and Japanese stock markets. The S&P 500 index of big American companies is up by 5%, having passed 5,000 for the first time. In February, Japan’s Nikkei 225 passed its own record set in 1989.
The report included studies by Anarkulova, Cederburg and O’Doherty who make a case for a portfolio of 100% equities through a review based on data going back to 1890. Ayres and Nalebuff of Yale University even argued for a strategy of borrowing by young people in order to buy stocks, before diversifying and deleveraging later in life. However, an even longer view by McQuarrie dating back to the late 18th century showed decades when bonds outperformed stocks.
Of course, this view is contrary to mainstream belief that a good mixture of stocks and bonds works best for the regular investor. The US and Japan equity indices may be at all-time highs, but for how long? The stock concentration argument is based on the very long run. And in that same period, we are all dead unless we are blessed with the magic of one famous centenarian politician. The gyration of the markets still supports a more balanced perspective.
It is true that the potential for high return exists in equity, but it comes with an equally high level of risk and volatility. Stock prices can be unpredictable, influenced by various factors like economic conditions, geopolitical events, and company performance. Prices can fluctuate significantly in a short period, and one may experience substantial losses. It could jeopardize financial stability, especially if access to savings is an exigency for the short term.
Diversification involves spreading your investments across different asset classes and securities to reduce risk and enhance the potential for returns. Different asset classes such as stocks, bonds, real estate and cash equivalents have unique risk and return characteristics. By allocating across various classes, the benefit is when assets perform differently under different economic conditions. When stocks face a downturn, bonds or real estate may offer stability or even appreciate. In China today, for example, young investors have been buying gold as a refuge from local property and stock market mayhem.
Statistics play a crucial role in assessing the effectiveness of diversification. Modern Portfolio Theory (MPT) developed by Henry Markowitz is a statistical framework that formalizes the concept of diversification. MPT uses statistical measures like expected return, standard deviation, and covariance to optimize portfolio allocation.
The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.
BENEL DELA PAZ LAGUA was previously EVP and chief development officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs.