Diversification overrated? Not a chance by Jason Zweig
For anyone with a sustainable ability to identify the hottest investment of the moment, diversification is a mistake. But if you really believe you’ve got that ability, you’re not just mistaken. You need to be hauled off in a straitjacket to the Institute for the Treatment of Investment Insanity.
Exactly right. As we posted previously Warren Buffett’s diversification thoughts are similar
You have to remember when Warren Buffett says “professional and have confidence” he doesn’t really mean just what those words say. He mean if you are Charlie Munger, George Soros, Jimmy Rodgers and maybe 10 other people alive today (maybe I am too restrictive, maybe he would include 50 more people alive today, but I doubt it).
Related: Dilbert on Investing - investment risks - Curious Cat Investing and Economics Search Engine
In his blog Scott Adams, author of Dilbert, provides often quite intelligent and interesting thoughts. In a recent post he wrote on investing and Diversification:
I didn’t own much in the way of stocks for the past several years, thanks to not using professional advisors. A big chunk of my money has been in California Municipal bonds of various types, and all are insured.
…
In order to diversify more, I started migrating money over to the stock market during this recent plunge. The market could go a lot lower still, but this is either the beginning of the end of the United States as we know it, in which case it doesn’t matter how I invested, or it is a once-in-a-lifetime stock buying opportunity. It was an easy decision.
Related: Stock Market Decline - Warren Buffett on Diversification - Investment Allocations Make A Big Difference
‘Armageddon’ Prices Fail to Lure Buyers Amid Selling
…
The selling is being compounded by hedge funds and mutual funds dumping holdings to meet redemptions, which may push prices even lower, according to analysts at UBS AG.
…
Corporate debt has been pressured by “incessant selling by hedge funds and leveraged institutions as they unwind,” Bill Gross, manager of the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co.
…
Corporate bond prices plunged to 79.9 cents on the dollar on average from 94 cents at the end of August and 99 cents at the end of 2007, according to index data compiled by New York-based Merrill Lynch & Co.
…
“The de-leveraging that we’re witnessing will probably continue,” said Paul Scanlon, team leader for U.S. high yield and bank loans at Boston-based Putnam Investments LLC, which manages $55 billion in fixed income. “My sense is that’s not turning around in the very near term.”
I am not very familiar with the bond market but it does seem like the panic is in full swing but calling the bottom is always hard. I would guess the de-leveraging (and investors pulling money out of bond funds) could well lead things lower over the short term.
Related: Corporate and Government Bond Rates Graph - Municipal Bonds After Tax Return
Over the last 3 months the yields on corporate bonds have increased while treasury bonds have decreased. The chart shows the move away from lower quality bonds to higher quality though probably not as dramatically as actually has taken place as it is just an average for each month (and in September the flight to quality became extreme at the end of the month). While the Fed did not announce a formal cut in the discount rate, the average rate for overnight loans from the Fed last month was 1.81%.
The spread between 10 year Aaa corporate bond yields and 10 year government bonds increased to 196 basis points. In January, 2008 the spread was 159 points. The larger the spread the more people demand in interest, to compensate for the increased risk. The spread between government bonds and Baa corporate bonds increased to 362 basis points, the spread was 280 basis point in January. The rate on government bonds has barely change (decreasing from 3.74% in January to 3.69% now) so the change has nearly all been in increased corporate bond rates.
Data from the federal reserve - corporate Aaa - corporate Baa - ten year treasury - fed funds
Related: Bond Yields 2005 to June 2008 - 30 Year Fixed Mortgage Rates versus the Fed Funds Rate - Curious Cat Investing and Economics Search - posts on interest rates
Why Allocations Make A Big Difference
Good advice, but I believe people need to be much more careful with bonds than many people believe. Long term bonds can be volatile (both due to interest rate and other risks). And with interest rates low this risk is higher. The duration of your bonds (as well as credit/business risk) is a very important factor (the longer the duration the higher the interest rate risk).
I also think the importance of asset allocation increases as your assets increase and the goal gets closer (normally retirement but also could be a child’s education fund…). And I think you need to look at more than just stocks versus bonds (different types of stocks, real estate… are important considerations). I discussed some possible retirement account allocations possibilities for early in life in a previous post.
Related: Lazy Portfolio Results - Investing books - Roth IRA - Dollar Cost Averaging
Over the last 2 months the yields on bonds have increased the discount rate has continued to decline.
The spread between corporate bond yields and government bonds has decreased a bit as treasury yields have increased 37 basis points compared to just 4 and 6 basis point increased in corporate bond yields.
Data from the federal reserve - corporate Aaa - corporate Baa - ten year treasury - fed funds
Related: Bond Yields 2005-2008 - 30 Year Fixed Mortgage Rates versus the Fed Funds Rate - Initial Retirement Account Allocations
From January 2005 to July 2007 the Federal Funds Rate was steadily increased. The rate was held for a year. Since then the rate has been decreasing (dramatically, recently). As you can see from the chart, 10 year bond yields have been much less variable. The chart also shows 10 year corporate bond yields increasing in February and March when the federal funds rate fell well over 100 basis points.
Treasury bond yields are down but a huge part of the reason is a “flight to quality,” where investors are reluctant to hold other bonds (so they buy treasuries when they sell those bonds). Therefore other bond yields (and mortgage rates) are not decreasing. I guessed last month that the data “may well decrease some for both 10 year bonds once the March data is posted” which wasn’t the case. But I was right in “expect[ing] the spread between treasuries be larger than it was in January.”
Data from the federal reserve - corporate Aaa - corporate Baa - ten year treasury - fed funds
Related: 30 Year Fixed Mortgage Rates versus the Fed Funds Rate - After Tax Return on Municipal Bonds