Monday, August 22, 2016

Is the Fed Undermining Portfolio Diversification?

A basic investment strategy for investors is to diversify.  Typically, investors put some of their money into stocks, and most of the rest into bonds.  Small portions may go into gold or other commodities, or be held as cash.  Stocks and bonds historically have tended to offset each other.  When stocks rose, bonds would fall, and vice versa.  A diversified portfolio would be hedged, ameliorating the ups and downs of the market and making investing less stressful. 

Today, though, central bank accommodation--in the form of ultra low interest rates, negative interest rates and quantitative easing--has distorted this historical relationship.  As the Fed and other central banks print more and more money, both stocks and bonds rise in value.  They no longer offset, and diversified portfolios are becoming unhedged.  If and when the era of easy money ends, both stocks and bonds could fall, and perhaps precipitously.   

By unhedging diversified portfolios, the central banks are heightening investor risks.  Many wealthy and institutional investors, apparently sensing the danger, have been increasing their levels of cash.  But ordinary mom and pop 401(k) investors may not be able to shift gears so easily.  They may face increasing exposure, and perhaps not know it.  If they sustain losses when they expected to be hedged, they could lose confidence in the markets.  The result could be rapid and ugly.  That's what happened on Black Monday, October 19, 1987, when the stock market crashed and fell 22.61% in a single day because many institutional investors thought they'd be hedged by a financial product called portfolio insurance and found out unexpectedly that portfolio insurance didn't work. 

The central banks could reduce accommodative policies in order to raise rates and normalize the financial markets.  But that process could cause investor losses and trigger selling that leads to a market meltdown.  If, on the other hand, central banks keep printing money, they may worsen the problem.  You could shift more assets to cash (or at least refrain from committing fresh cash to the markets).  Otherwise, understand that diversification, like everything else in the financial markets, is starting to look a little hinky.

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