Ask an advisor: How can I diversify my investments?

Ask an advisor: How can I diversify when both stocks and bonds are down?

May 1, 2023 6:03 PM

The bear market of the early 2020s has hurt both stocks and bonds.

Welcome back to "Ask an Advisor," the advice column where real financial professionals answer questions from real people. The topic can be anything in the world of finance, from retirement to taxes to wealth management — or even advice on advising.

It's been a tough year and a half for investors. In the first half of 2022, runaway inflation soared to 9.1%, its highest point in four decades. That spurred the Federal Reserve to raise interest rates not once, but nine consecutive times, hoisting the federal funds rate from near-zero in March 2022 to almost 5% one year later — the highest it's been since 2007.

The results hit the stock market hard. Last year, the S&P 500, Nasdaq and Dow Jones each suffered its worst year since 2008, with the S&P down 19.4%.

But any investor who ran to bonds for safety would have been sorely disappointed. Though bonds' interest rates increased, their prices plunged. The Barclay's U.S. Aggregate Bond Index, for example, was down 13% by the end of 2022 — its worst year on record.

Where can investors turn for relief? Wealth managers typically encourage clients to diversify their assets, but how is that possible when both stocks and bonds seem to be suffering in tandem? In today's highly interconnected economy, is there any way for investors to hedge their bets?

A tech specialist in New York has been grappling with these questions and reached out to the experts for help. Here's what he wrote:

Dear advisors,

Is it possible to truly diversify your investments? It seems like these days all assets are connected, and everything goes up or down in value according to the latest interest rates.

I'm a 36-year-old tech entrepreneur in New York City, and I'm investing both for my retirement and for a startup I'm working to launch soon. I have about $30,000 in my 401(k) and about $100,000 invested in index funds. I've tried to diversify the index funds by going 60% domestic, 40% foreign.

Retirement

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April 30, 2023 6:00 AM

Should I be doing more to mix it up? Is that even possible? It would be great if some totally separate asset like Pokémon cards could act as a hedge, but it really seems like all things are correlated.

Thanks in advance,

Mixed Up in Manhattan

And here's what financial advisors wrote back:

Give bonds a chance

Joey Loss, a certified financial planner and the founder of

Flow Financial

in Jacksonville, Florida

In the current environment, it does appear that nearly all asset classes are moving together. It's worth noting that they aren't all moving with the same intensity though. While bonds have had a rough go of it lately, they are still proving less volatile than equities. It sounds like adding some fixed income (bond funds) to your overall portfolio might help you reduce the intensity of that volatility over time.

Additionally, for those who plan to spend money in the near to intermediate future, it may be worth exploring high-yield cash savings accounts available in the current landscape.

Ideally, investors should reduce the risk of assets they plan to spend as that moment of spending approaches. If the start-up is in your sights in the next few years, cash may be the safest place to earn some interest while avoiding a drop in value the day before you need to put that cash to work.

Not all stocks are created equal

Devin Pope, a certified financial planner and senior advisor at

Nilsine Partners

in Salt Lake City, Utah

You can get diversification by owning different types of equities, in terms of market cap or sector allocations. For instance, energy did very well last year, while tech did not. If you had a larger tilt toward energy and away from tech, you would have benefited.

An investor can also diversify by asset class. You can own equities, fixed income, cash, real estate or alternatives. There are also public securities and private securities. Most investors have their money in public securities, but there are ways to diversify by owning private investments. The world of private investments is becoming more available to investors and makes sense as part of an allocation.

Consider the alternatives

Jesse Whitsit, a certified financial planner at

Morgan Stanley

in Hauppauge, New York

Yes, you can diversify your assets further to increase your returns and lower your risk. Your 401(k) has limited funds to choose from and may not have a lot of diversified options.

However, if the $100,000 of index funds is in a self-directed brokerage account, it can be diversified further into alternative investments (e.g. gold, equity market neutral strategies, private credit/equity, etc.). These assets are often unrelated to interest rate movements and equity markets. Depending on the client's wealth, art assets — even Pokémon cards — can act as a hedge because the collectors' estimated value is not related to the overall economy.

Rethink the hedge

Noah Damsky, a chartered financial analyst and principal at

Marina Wealth Advisors

in Los Angeles

A hedge sounds great, but most of the time investors don't love how it plays out in practice. Hedges are intended to go up when the rest of the portfolio goes down, but the flip side is that they will often go down as the rest of the portfolio goes up. Being satisfied with your hedge declining in value as the rest of the portfolio does well can be a mental roadblock.

Sophisticated institutional investors implement hedges, such as commodities, which can go up when stocks suffer, but that takes a lot of discipline and know-how. If you're up for it, then go ahead. For everyday investors, bonds should do the trick.

Follow the trends

Mark Wilson, a certified financial planner and the founder of

MILE Wealth Management

in Irvine, California

An old, geeky line applies here: "The only thing that goes up during a bear market is correlation."

Unfortunately, stocks are stocks. Over long periods of time, large-cap, small-cap, international, value and growth stocks will not act exactly the same. But, when investors get scared, all stocks are sold off.

In 2022, even bonds did not provide any protection. Massive interest rate hikes (due to inflation spikes) were the driver of both bond and stock declines. With rates in the 5% range, I expect bonds to again provide benefits when stocks falter. I like bonds today more than I have in a decade.

Emerging market stocks, foreign bonds, REITs, and commodities all tend to correlate when we do not want them to, so they do not make good short-term diversifiers. (Commodities were a bright spot in 2022.)

There are a handful of true alternatives (not Pokémon cards) that did their job last year. Reinsurance, private real estate, private real assets, and (especially) trend following all held up very well in 2022.

Unfortunately, most of these are difficult for a "retail" investor to access. The most difficult part is that diversifiers are very hard to own. If you do not have the stomach for a holding that looks bad for three years out of five (compared to stocks and bonds), these holdings are going to disappoint. Also, owning a 3% position is not going to provide any noticeable benefits.

But if you can hang in there, trend following ("managed futures") funds are probably the best option for you to consider.