Portfolio Diversification in Action

On 02/16/2011, in Investment Strategies, by Jordan Wilson

The Wall Street Journal (WSJ) had a nice article entitled How to Profit From Inflation.

In my post Investment Lessons From Inflation, I attempted to demonstrate how inflation related to some of the topics we have considered in this blog.

The WSJ article also provides real world examples on how portfolio diversification can protect against inflation.

We will now see how the concept of portfolio diversification applies to actual investing tactics. 

The WSJ article provides practical investment tips for addressing inflation.

Diversify Within an Asset Class

One way to protect your capital might be to diversify within the asset class.

For example, the article recommends selling long-term bonds. A good idea.

As inflation hits, interest rates will rise. As rates rise, bond prices fall. The longer the term to maturity, the more sensitive a bond will be to interest rate changes. So the greater the negative price impact.

Instead, you should significantly shorten maturities and also look at investing in real-return bonds. This will provide some protection from inflation.

This strategy is useful if you expect inflation. If you do not plan for inflation and lower interest rates, stick with longer maturities.

If you are unsure about what the future holds, then hedge your positions. Hold some long-term bonds, some medium, and some short-term. With real return assets mixed in. If there is inflation, you will lose on the long-term assets, but profit on the short-term and real return. If interest rates fall, the opposite is true.

By diversifying with the asset class, you can spread the risk around and better protect your overall portfolio.

Diversify Across Asset Classes

You should also look at diversifying between different asset classes.

When interest rates rise due to inflation, bonds may not be a good investment.

But common shares may be an attractive alternative. Avoid stocks that are sensitive to interest rates. Utilities and consumer products are typical of this group. But companies that are not inflation sensitive may provide excellent diversification potential.

The same may apply to investments that do well in inflationary conditions. Commodities often fit this profile. Hard assets are another.

The WSJ article is not bullish on hard assets. But their reasoning has more to do with other factors than inflation. Real estate is suffering from too much inventory available and too much debt held by existing real estate investors. Gold is an issue simply because it has appreciated greatly in recent years. Whether current gold prices already reflect the coming inflation is debatable. It may be that there is further room for price increases.

With reduced inflation and decreasing interest rates, you will do well with bonds and certain interest rate reliant equities. At the same time, commodities, hard asset assets, and other stocks may underperform.

But in times of increasing inflation and interest rates, you likely will be better off taking the reverse positions.

And by having a mix of investments, you will have some protection whether interest rates and inflation rise or fall.

How does all this relate to the theory of portfolio diversification?

Asset Correlations

Asset correlations reflect how one asset moves in relation to another.

Properly using asset correlations in assembling a portfolio is key to optimizing total returns.

The lower the correlation coefficient between two assets, the better the diversification benefit.

In the WSJ article, we see how one should invest in the event of inflation. But how do these recommendations translate when we look at actual asset correlation coefficients?

If we look at February 15, 2011 data from Asset Correlations, the numbers bear out well.

In their bond correlation matrix, 20 year Treasury Bonds have a −0.15 correlation to short-term Treasury Bills.

And in comparing major asset classes, U.S. Bonds have a −0.23 correlation to U.S. Small Cap Stocks. U.S. Bonds also have a −0.16 correlation to the Commodities Index, 0.03 correlation to U.S. Real Estate, and 0.15 to Gold.

The negative numbers indicate that as one asset rises, the other should fall.

This is the underlying principle applied in the specific WSJ recommendations made for dealing with inflation. As inflation negatively affects bonds, investors should seek assets with low or negative correlations to bonds. Small cap stocks, commodities, real estate, and gold are such assets. It is no coincidence that these type assets are proposed in the article.

A good article.

I hope it helps you tie the theory of portfolio diversification to real world investment tactics.

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