Lessons Learned

Two recent MetLife studies have shown that on one point financial advisers and baby boomer clients are remarkably aligned: It is more important to protect assets from losses than to achieve market gains.

As we have shown before losses really hurt investor's portfolios. Three years of 20% gains followed by a loss of 20% turns the total gain into a pedestrian 8 plus percent. A fifty percent gain followed by a 40% loss does not leave an extra 10% to the good. It's a LOSS (100 x 50= 150; 150 x (1-.40)= 90.

So what do advisers do about risk of loss? 74% recommend diversification according to MetLife. But apparently only 28% of baby boomers are taking that advice. Know what I say? I'm with the baby boomers! Diversification as practiced and preached is wrong-headed. Why? Because the only TRUE diversification is not among asset classes which show HISTORICAL non-correlation. That is looking in the rear view mirror and attempting to drive the car! As we have seen, in declining markets asset classes all tend to go toward a correlation of one. The only diversification occurs among asset classes that have DIFFERENT VALUATIONS. Asset classes that are valued richly decline rapidly. Asset classes that are undervalued decline less rapidly or even go up. As an example take small cap value stocks and REITs in 2000-2002. The market had shunned them for years. If you liked REITs during the tech bubble you were eating thin gruel for returns. But the bubble bursts and viola! happy days were here again. Most stocks went down. REITs and small cap value more than held their own. Why didn't this work in 2008-09? All asset classes except bonds were richly valued. Every one. REITs, utilities, commodities, international stocks. The explosion in cheap credit and money chasing whatever return it could find assured that. When the market started declining they all went down. The only exception was bonds! End of story (and benefits of diversification).

So if you want diversification, check the historical valuation of the asset class being suggested. Can it be done? Sure it can. An asset allocation shop like GMO (which we've written about before) does it all the time. Then, take a tip from Mark: If it's high, it won't diversify. (Apologies to Johnny Cochrane)