1. The Importance of Diversification I believe in the merits of diversification when constructing a portfolio, as the diminished covariance among assets can and will materially reduce returns volatility over time. The lower the correlation between assets the greater the reward-to-risk ratio. The math works out such that if you can invest in just 4 equal-returning, uncorrelated assets you will improve your reward-to-risk (R/R) ratio by a factor of 2. If you invest in 9, you improve R/R by a factor of 3. With 16, 4; with 25, 5. Note the very clean mathematical relationship wherein R/R is improved by another factor whenever a “perfect square” number of assets are added. Graphically (click to enlarge): (Source: author) If the correlation between assets increases to 25%, improving R/R becomes markedly more difficult. With 4 assets, just 33% of the risk is reduced from owning just 1 asset. With 9 assets, risk is reduced by 42%. Beyond around the 9-12 asset mark, risk won’t be reduced too noticeably. (Source: author) As one can imagine, when correlation among assets increases to 50%, the reduction in risk begins to plateau even more quickly and at a higher level. Beyond 6-8 assets, risk will still remain 70%-75% of that of the one-asset portfolio regardless of how many are accumulated. (Source: author) At 75% correlation – basically a 100% equities portfolio – your risk will still be about 87% of that of the one-asset portfolio regardless of how many are added. When you go from asset #4 to asset #5, you are already reducing your risk by less than one percentage point. (Source: author) Takeaway The better you can diversify among asset classes, the better the risk-adjusted returns of the portfolio, which can also permit the use of more leverage to improve returns. This means some mix of stocks, bonds, high-yield, REITs, inflation-protected assets, corporate bonds, safe bonds, and a little bit of gold. 2. Correlations Among The Main Asset Classes The correlation among these assets can be observed below: The biggest negative correlation among the bunch is between US stocks (SPY) and long-duration US Treasuries (TLT) at -0.45. Gold (GLD) has virtually no correlation with stocks or bonds, is inversely correlated with the US dollar (UUP) as an alternative currency and positively correlated with oil (OIL) (through the dollar, as a cheaper dollar means cheaper oil, which equals more demand for it). Gold is positively correlated with Treasury inflation-protected securities (TIPS) given both act as inflation hedges. It is very mildly correlated with Treasury bonds more generically as both are seen as safe haven assets. Stocks are positively correlated with oil and negatively correlated with bonds and the dollar. High-yield credit (HYG) is also positively correlated with oil (higher oil is generally good for energy businesses and higher energy input costs are generally passed off to consumers for other business models). However, given higher oil is inflationary, and inflation is negative for the returns of fixed-yield credit, the positive correlation between high-yield and oil is lower than that between oil and stocks. The dollar is basically negatively correlated with everything, aside from no virtual correlation with safe bonds. This is actually a good thing, given most US-based investors have their portfolios denominated in USD and thus acts as a natural hedge. Long-duration Treasuries are the best hedge against underperformance in risk assets. Treasuries were almost the only asset class that outperformed cash during the financial crisis. 3. How Low Rates And QE Have Skewed Relative Valuations The chart below shows total US stock market capitalization relative to nominal GDP. As we can see, stocks are valued the highest they’ve ever been according to this relationship. (Source: St. Louis Federal Reserve) Note that this doesn’t “prove” that stocks are “overvalued,” as low rates and central banks have pushed more wealth into the financial markets in order to create more wealth in the financial system, which theoretically benefits the economy through more consumption and private sector investment. Assuming rates are “lower for longer,” expect market cap-to-GDP ratios to remain elevated in conjunction.