What’s the point of portfolio diversification?

M

MrAgi1

As we know 2022 have not really been a good year for the stock market. It got me thinking and I have a lot of questions. Bonds which are supposed to be inversely correlated in times of market crash or recession are not that useful in high interest rate periods because bond prices falls. Not sure what is the point of the traditional 60/40 portfolio split in that case. For the case of market crash like early 2020 covid crash, even zero and inverse correlated stocks decided to go same direction.

Now from the perspective of a novice trader and not an investor, I have a few questions to ask.

1. How does the crash in the US stock market affect the currency market? For example: would crash in the US market affect a non related currency pair like the CHF/JPY? Can forex market be used for portfolio diversification instead of bonds?

2. What about the commodity markets? Specifically things agro(like cocoa, cotton, rice)? I know things like gold are supposed to serve like an hedge but sometimes they may be indifferent or even fall during times of crash or recession? Can commodities be used for portfolio diversification instead of bonds?

3. Finally, are there other other trade-able asset classes that are indifferent(not necessarily inversely correlated) to the stock market in time of recession or crash?
 
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1. SPX down, USD up - as short term correlation here (all markets are interconnected to each other)
2. SPX down, Gold down too short term
3. Cash or market neutral positions
 
I will never buy any more stocks, trade for long term trends in commodities and forex, also do credit spreads on stocks, ETF's and futures.

To me diversification is using your money wisely, getting the most bang for your buck.
 
MrAgi1 said:
Can forex market be used for portfolio diversification instead of bonds?
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Can commodities be used for portfolio diversification instead of bonds?
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Anything can be used for portfolio diversification instead of bonds. Be it grandma's rare post sign collection of your favorite old wine.

But using bonds for retailer portfolio makes little sense. Institutionals are using them because they play on a different level when it comes to size.
(And ofcourse it's safer, yet they have to play it safe because they must report back to goverments/central banks)

And if using bonds as a retailer makes little sense, then using forex or commodities sounds twice as bad, because all of it is screaming :

,,I don't know what i am doing with my money, but i'll pretend to be a hedge fund manager and see how it goes"

Instead get good at stockpicking, or use simple DCA into SPY or VOO. The returns from bonds long term are so tragic that it is, not worth it.
 
MrAgi1 said:
As we know 2022 have not really been a good year for the stock market.

3. Finally, are there other other trade-able asset classes that are indifferent(not necessarily inversely correlated) to the stock market in time of recession or crash?
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%%
Plenty.
Plenty of business that differs even though part of 2008+ 2009 maybe be similiar to SPY benchmark.
I asked the metals dealer if she had bought much gold this year??
No, but plenty of copper,[1970 chart thru now] iron ................................
In other words, to paraphrase Mark Cuban , dont look only, where many people look.
 
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The 60/40 portfolio has performed fine overall. 2022 is an outlier -- it's one of the worst performing on record.

60-40 portfolio.jpg


In terms of correlations with other markets nothing is guaranteed. To see how specific combinations would have worked you have to do some backtesting. And this will only give you probabilities, i.e. gold was a good hedge 55% of the time, the S&P gained on a weekly basis 57% of the time, etc. Trading in this way only works if you do a lot of trades and you stick to the system / method for a period of time that allows for a lot of trades. This will depend on the timing of your system (hourly, daily, weekly, etc.).
 
The purpose of diversification is to create the risk profile that you want, for yourself. For example, the distribution of daily/monthly/yearly outcomes from holding just S&P, holding 70% S&P and 30% cash, 50% S&P and 50% Bonds, 20% S&P and 20% IYR and 20% AGG, etc. are all going to be different. You are simply changing your risk profile.

There's no way to get a great passive diversified strategy where you do well in all markets. Such a strategy would be exploited and then no longer coexist. Markets are not always efficient, but you are not going to be able to create a passive strategy that protects you from downturns and brings you more or almost as much gain during uptrends. Not over a multi-decade period. There are countless people doing this as portfolio managers and you will not find a passive portfolio that has a better risk profile than what other portfolio managers are doing (over the long run). You get compensated for taking risk, in general. If an index is more volatile and has a scary risk profile you expect to get compensated more in uptrends. If it is less, than you receive less in uptrends. Simplistic, but just trying to give an example.

I wouldn't think you'd diversify long term with currency and commodities have weak returns over the long haul. Perhaps some gold/silver exposure for commodities, but it's hard to have any kind of expectation of what your long-term multi-decade risk profile would look like from this.

You can't get something for nothing. If the risk free rate is 3%, for example, if someone wants to earn more than 3% they have to taken on downside risk. How you set up your passive portfolio is simply choosing a future distribution you are comfortable with and as a distribution has randomness/unknown, you are always subject to loss and awful tails as you mention with bonds in 2022.
 
An interesting study about portfolio diversification among different asset classes here.

https://mpra.ub.uni-muenchen.de/103870/1/MPRA_paper_103870.pdf

Abstract
We propose a stochastic spanning approach to assess whether a traditional portfolio of stocks and bonds spans augmented portfolios including commodities, foreign exchange, and real estate. We empirically show that in all seven portfolio combinations, the augmented portfolio is not spanned by the traditional one. Our results are further confirmed by both parametric and non-parametric tests in an out-of-sample setting. Therefore, traditional investors can generally benefit in terms of higher Sharpe ratios from augmenting their portfolio with alternative asset classes. Additional analysis demonstrates that diversification benefits can be explained by the current state of the U.S. economy and stock markets.
 

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MrAgi1 said:
As we know 2022 have not really been a good year for the stock market. It got me thinking and I have a lot of questions. Bonds which are supposed to be inversely correlated in times of market crash or recession are not that useful in high interest rate periods because bond prices falls. Not sure what is the point of the traditional 60/40 portfolio split in that case. For the case of market crash like early 2020 covid crash, even zero and inverse correlated stocks decided to go same direction.

Now from the perspective of a novice trader and not an investor, I have a few questions to ask.

1. How does the crash in the US stock market affect the currency market? For example: would crash in the US market affect a non related currency pair like the CHF/JPY? Can forex market be used for portfolio diversification instead of bonds?

2. What about the commodity markets? Specifically things agro(like cocoa, cotton, rice)? I know things like gold are supposed to serve like an hedge but sometimes they may be indifferent or even fall during times of crash or recession? Can commodities be used for portfolio diversification instead of bonds?

3. Finally, are there other other trade-able asset classes that are indifferent(not necessarily inversely correlated) to the stock market in time of recession or crash?
More...
Hello MrAgi1,

I do not like diversification. Long and Strong SP 500 index until the account +2 million dollars, and then cash out. It only goes one way the past 122 years, UP. Alwyas keep it simple.

Best to keep it simple and play the long game.
 
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