Toro
Diamond Member
What is "etc." ?
That's the trouble with the diversification myth. Its usually stated as "diversification means stocks, bonds, real estate, etc." and there is no explanation of the etc. First of - stocks and real estate together aren't really that diverse, as the past economic collapse should show you. In fact, if you can find any point in time when the stock market crashed and real estate values remained the same or went up - or vice versa - I'd love to read about it (not saying such a time never existed, just that it would be surprising). Second off - the phrase use to be "stocks, bonds, etc" - then real estate got popular - then it became "stocks, bonds, real estate, etc". Diversification really means "stocks, bonds, whatever is popular to invest in, etc".
I said "etc." because I was being lazy.
The etc. is a variety of not only assets but also risk premia and strategies. Assets include currencies, commodities, infrastructure, land, royalties, timber, foreign bonds, foreign stocks, and so on. Risk premia include carry, small cap and value stocks in equities, and so on. Strategies include divergent strategies such as managed futures. In 2008, the S&P 500 fell 38%. The Barclay's Agg rose 5%. Gold rose 5%. The Barclay Hedge CTA index rose 18%. Many risk parity strategies were down 5% or 10% in 2008.
Diversification moves one out on the efficient frontier. It is a free lunch in finance.
Another huge problem with the diversification myth is the idea that simply having varied assets protects you from loss while haven't non-varied assets exposes you to loss. This isn't the case. Take two portfolios:
Portfolio A)
Equal amounts of exposure to:
S&P 500
corn futures
bit coins
debt of the Mexican government
a worldwide small cap mutual fund
U.S. Treasuries
Portfolio B)
1) long position on Microsoft
2) a put option to sell Microsoft at 90% of what I bought it for
Now which portfolio is more diverse? Clearly Portfolio A! Which is safer from loss? Clearly, Portfolio B!
Portfolio B is a cash replicant. There is empirical research on this. Buying stocks and buying puts on those stocks generates a cash return. Actually, that's not true. It generates a slightly lower return than cash as put buyers tend to over-estimate risk.
So I would say Portfolio A is a better portfolio because it will likely generate a higher return for a commensurate amount of risk over time.
Business can continue to be profitable and at the same time the market might misjudge how profitable they will be. If it turns out Company A is 10X less profitable than the investors thought it would be, Company A is still profitable but its stock will probably drop about 10 fold unless investors think it will make a big turn around. Once the price drops, the P/E ratio becomes more sensible again and the company would appear to be "profitable" to a new investor.
I agree with that. That is why I said I don't always recommend people own stocks. Sometimes, stocks are very expensive and shouldn't be owned. However, over very long periods of time, 50 or 100 years, valuation levels become less important.
I've spent 20 years in capital markets. One of the lessons I tell new people is that in the short run, valuation doesn't matter. The only thing that matters in the short-run is sentiment. In the short-run, and even the intermediate-run, financial markets may not be efficient. In the long-run, however, they are. In the long-run, the only thing that matters is valuation.
I admit I'm still befuddled as to how a gain can "accrue to an asset" and actually be realized without someone having to pay money for it. I know you don't actually believe this - but from your statements thus far it would appear that you are trying to say that businesses just accrue gains without anyone actually having to pay for them - like there's some sort of accrual gremlins that come out when everyone is asleep, dropping risk premiums into the pockets of investors.
I may be wrong but it appears that you are concerned about how the returns are distributed intra-asset class, i.e. between stocks and bonds, as well as the prices paid of those securities. As I said above, I'm not entirely sure why there are risk premia, though I believe it has to do with uncertainty and cognitive biases that cannot be measured by the limited tools of statistics. Markets are raw human emotions at times, which leads to things that cannot be explained by rational behavior, i.e. the persistence of momentum and serial correlation of prices, and thus are not explainable by economists in today's intellectual framework.
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