iTrust Daily Insight

11th September
iTrust Daily Insight
Afternoon Edition 9.11.2019

September 11 — After Market Hours — Explanation of Magic of Diversification

Dear Reader —

Earlier today we provided a longer comment which included market prices from before the US equity markets opened today.

There wasn’t much news that moved markets enough to repeat reporting current market prices.  Tomorrow morning, we will list market prices in our economic commentary.

For now, I want to explain the “magic” of diversification.
For actual data of a well-regarded market prognosticator, please click on the link below for JP Morgan’s 100+ report published in October 2018 when they predicted their 2019 version of their Long Term Capital Market Assumptions.

Wilshire & Associates also publishes a well-regarded set of Long Term Capital Market Assumptions.

In the JP Morgan information, they say their Long Term Capital Market Assumption for US equities is about 7% and for US investment grade bonds (“aggregate index”) is about 4%.  However, they say a portfolio of 60% stocks & 40% bonds is assumed to provide a long term return of just over 6%.  (See the graphic on the bottom-right of page 6.)

Let’ do the quick math and assess how much is created by the “magic” of diversification.

The simple expected return from a portfolio of 60% of something assumed to return 7% (the portion allocated to stocks / equities) and 40% of something assumed to return 4% (the portion allocated to bonds / debt) is:

(60% x 7%) + (40% x 4%) = 4.2% + 1.6% = 5.8%

But, JP Morgan’s assumption for a portfolio of 60% stocks & 40% bonds is not 5.8%; it’s ~6.0%.

So, the portion of assumed long term investment returns attributable to what I call the “magic” of diversification is 0.2 percentage points, or, in Wall Street parlance, about 20 basis points.

This magic is caused by the low correlation between stock market returns and bond market returns.  In other words, sometimes when the stock market is down, the bond market goes up.  Both markets are expected to provide long term positive returns but the diversification reduces the cost of down-markets.  Keeping the discussion simple, we will end the discussion there regarding the benefits and causes of the “magic” of diversification.

Please contact iTrust Capital’s Blake Skadron if you’d like to learn more about the benefits and causes of diversification.  He can get you in touch with me and I’d be happy to share more.

In JP Morgan’s “matrix” of correlations in the report at the below link, gold has a negative correlation with US stocks.  In addition to being a good store of wealth and a potential use as a currency in times of distress, some gold buyers buy gold due to this widely known and expected negative correlation between investment returns of gold and US equities.

From what others have reported, there seems to be some speculation that investment returns from digital currencies may also have low or negative correlations to major asset classes such as US equities.  From those same others’ reporting, this seems to be causing interest among institutional investors to investigate those correlations.

Therefore, some digital currency buyers may be purchasing now in the hope that institutional investors’ research will cause them to buy digital currencies and drive up prices if they do.

We do not have a view whether such research is actually taking place or what their findings may be.

But we know there is a lot assumed in some reporting and we wanted to explain why correlations and diversification are important and how digital currencies may have a role in the portfolios of investors seeking to increase the factor attributed to the “magic” of diversification in their portfolios.

JP Morgan’s 2019 report of Long Term Capital Market Assumptions, published October 2018:

Tim Shaler is Chief Economist of iTrust Capital.  He is a published Real Estate economist, was a portfolio manager and asset allocation expert at his previous firms and is an adjunct professor at Webster University. His MBA (Finance) and MA in Russian Economic History are both from the University of Chicago.

For all media inquiries, please contact Blake Skadron at b.skadron@itrustcapital.com

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