The Dividend Cafe - The New Rules of Diversification

Episode Date: March 4, 2022

The fog of war continues in Ukraine with the entire world watching. The path to some immediate resolution has mostly closed, and expectations are for a complicated and extended process. Prayers are for minimal bloodshed and certainly for a limited scope to where the conflict goes. But few analysts are able to formulate a scenario where this ends well. The dollar is rallying. The Euro is collapsing. Oil is skyrocketing. U.S. equity markets are experiencing significant gyrations up and down day by day. I believe those five sentences summarize the five most important themes in financial markets right now (the collapse of the ruble and the Russian equity markets does not make the list, because who cares). I could certainly provide commentary today on the history of how markets have responded to various geopolitical distresses over the years, and maybe that will be needed in the weeks to come. But I believe longtime readers of Dividend Cafe know that I believe a properly constructed asset allocation is supposed to account for the inevitability of, well, distress. It could be geopolitical, or medical, or monetary, or economic, but distress is not new – only the specific reasons for the various particular distresses that come at different times. Today we are going to look at the reality of addressing distress in one’s portfolio through asset allocation – what it means in the current moment, how some elements of this have changed, and why it hasn’t stopped mattering. I wouldn’t say this is a specifically Ukraine-focused Dividend Cafe, but I would say that it may feel like it if it is understood correctly. We hold principles for the purpose of applying them during times of distress. The Ukraine event is a time of distress. Today’s Dividend Cafe is about the principles that exist before, during, and after such. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to another weekly episode of the Dividend Cafe. I have just gotten off of an airplane and run to my house to be able to record this before I now go on to my next destination. So it's been kind of a crazy week. And that's not just true of my schedule and the things that we have going on right now in our portfolio management and my research projects and in our client discussions. But it's obviously true in the market as well.

discussions, but it's obviously true in the market as well. And I want to talk to you about something today that I think will have the appearance of being unrelated to the Ukraine situation. And yet I do believe for more thoughtful listeners and viewers, they may connect the dots a little bit to Ukraine. It is a talk I want to give that if Ukraine were not happening, I could still give. And if there was something else happening, a different distress event in the global economy that maybe was or was not geopolitical or monetary or pandemic or macroeconomic, whatever the category may be, is somewhat irrelevant. But what we're going through right now has to do with the geopolitical uncertainty of Russia's ungodly invasion of Ukraine. And if we weren't going through that, we would be going through

something else and such is the story of history. Well, in a weird way, I'm accidentally segwaying to what I want to talk about because I believe that there is a way in which people look at investment markets that in a lot of ways, whether it's consciously or not, whether there's self-awareness to this or not, is very similar to the way I think people on one side or the other fall as to how they view humanity and history. When we look to people's engagement with political discourse, with their overall social theory that they believe in about society. I believe that there was a book written, I think it came out in 1987. I know it was back when I was first entering high school that profoundly impacted me. when I was first entering high school that profoundly impacted me.

And I think it has a lot of wisdom from the incomparable Thomas Sowell, wrote a book called Conflict Divisions. And the underlying thesis was that there is essentially, of all the different nuances and divisions and subdivisions, there are those who view human nature as something that is malleable, that is flexible, that is altering throughout history. And that there is a sort of perfectibility that we are striving for in society. foreign society. And then there are those, what he called the constrained division, who believe that human nature is immutable, that it does not change, and that there is an imperfectibility that forces us to manage societal affairs through the concept of trade-offs, through the acceptance of trade-offs. There's economic ramifications to that, but also political and social and cultural ones as well.

So what is this up to investment philosophy? Well, I think that there are those who are trigger happy to the idea that something is changing. are trigger happy to the idea that something is changing. And there are those that are predisposed to believe that there are kind of immutable laws and principles that govern the nature of investing. And that I do fall into that latter camp. There's a very high burden for me to believe that a particular principle or law could be altered or changed. And this is, of course, coincident with my view of social theory and political philosophy and so forth as well. If you will, it's sort of a political epistemology that the way in which one understands things and views things, I come from a more constrained vision. But when it comes to this changeability of human nature, when we're talking about

soul's paradigm of a conflict of visions, but right now I'm talking about investment philosophy and financial markets at large. I believe that those laws do not necessarily change. And yet the immediate response that one has to face now with the words that just came out of my mouth are that you are opposed to adaptation, that you are inflexible about the fact that things do change, that there are circumstantial evolutions that one has to account for in the way that they formulate a portfolio strategy. And I believe it's a very unfair accusation that what I'm referring to is an acknowledgement of different circumstances and catalysts and conditions, but that coexist with unchanged laws and principles. And why am I talking about this today? Why is this sort of high level armchairing and philosophizing about portfolio philosophy important? Well, first of all, the whole topic is important.

It's important when you talk about souls conflict divisions because it's a completely transformative understanding of human nature and the way people view human nature and the way that their view of human nature informs their entire view of society. But apart from that, when it comes to investment management, it's very important to me that my clients understand where I'm coming from philosophically and where others are coming from. Because there are people, even those that are outside the seduction of clickbaitism and financial journalism, there are those that genuinely have a true belief that things are just changing and that whole old thing we used to believe is gone and there's this new thing now. thing we used to believe is gone and there's this new thing now. And I think it is incredibly dangerous. And that when those have a low burden for believing that everything has just been completely churned, that they reject the lessons of tradition, of rules, of history, and oftentimes reject immutable economic principles,

that generally what comes out of that is incredibly dangerous, if not fatal. And so there is that camp of people that I think are predisposed to a hype, to a revolutionary view of investment markets. And then there are those that are predisposed to a view of being informed by history and believing in immutability of certain laws and principles. And so then I take the law of asset allocation and the kind of broad applicable principle that one blends various asset classes together to seek an optimal mix of risk and reward in a portfolio. And they do that for the purpose of achieving a goal.

And one of those goals has to do with keeping the investor invested. And so the moderation of downside volatility to be within a comfort level of an investor has psychological and emotional and ultimately behavioral ramifications that are very important. This is something I've studied and believed in for over 20 years and sought to apply in our business at the Bonson Group. All of our advisors are philosophically and then practically committed to this concept. And yet we're in a period of time where I think that principle is unchanged, but some of the catalysts that work within it, the application of it is enduring a transformation. And what I mean by that is

the core vanilla asset allocation idea of what we in our business refer to as a 60-40 portfolio. The idea that something in the range of 60% in equities and something in the range of 40% of bonds allows an investor to still capture enough of the upside of the 60% in equities to be goals-driven and successful, but that the 40% of bonds offsets the period of downside volatility that the equities inevitably provide without giving up so much of the return that the total net result is inadequate. And I think there's been periods where that idea has worked. There have been periods where that idea has not worked. But fundamental to the thinking behind the idea

was that the 40% in bonds were non-correlated to the 60% equities. That when equities were zigging downwards, the 40% of bonds were zagging upwards in a sort of non-correlative diversification benefit. And it's intuitively logical and in many periods, not all, practically beneficial. And that my belief is we're in a period where that concept of what we call boring bonds, safe treasuries, at the point at which the Fed got not just the short end of the curve, but the long end of the curve to near the zero bound, it lost its efficacy as an asset allocation strategy. So now we go into a period pre-Ukraine, you had an awful lot of equity market volatility that was not necessarily hitting our clients the same way because of the sort of good fortune of being

overweight energy and where value and dividend growth and things were actually not as impacted. But that could change at any point in time. And it certainly has been different for many periods for us. But really S&P, NASDAQ, big broad market indexes this year, suffering 10% to 15% volatility, while the treasuries were declining 6%, 7%, 8%. And this does not speak to an idiosyncratic event or a rare event or an outlier, an anomaly. I'm done with synonyms here. It speaks to an economic conclusion that the zero bound took away the muscle of treasuries in providing this asset allocation benefit. So I'm now in a position as we enter what I think will be a more prolonged period of volatility, a lot of uncertainty around the Russia-Ukraine aspect that requires the principle of asset allocation to not be forgotten and the application of it to be thoughtful. And what does that mean?

Well, we do believe in one aspect of what asset allocation, non-correlation, zigging and zagging seeks to do is a heavier implementation of alternatives to complement one's equities. But see, this doesn't provide a risk-free piece of the asset allocation, what we would refer to as sort of a safe haven or an anti-fragile asset. The non-correlation alternatives do bring in a different relationship between risk and reward relative to equities in the portfolio. But they do invite other risks such as manager selection, portfolio strategy, execution. That requires an incredible amount of due diligence and research by my team. And I think we do very well in our alternative procurement, but we do so because we invest a ton of time and energy and resources into it. And over the years, we've

developed personnel that are very gifted at doing this and we work hard at it. But that doesn't satisfy for the safe haven aspect. And I just want people to think about the idea. I put a chart at dividendcafe.com today of over the last 10 years, how Chinese government bonds, the sovereign debt issue out of China has done relative to gold, relative to German bond, relative to US treasury, relative to a whole host of what we would normally think about as these safe haven assets. Over the years, there's been various currency expectations. You think about the Swiss franc, you think about the euro, you think about the dollar. And what I would suggest is that we are living in a time where the anti-fragile asset is TBD. The safe haven asset is we're in search of what it may be. People have different agendas,

gold bugs want to scream from the hills, it's gold. I have arguments against that. I have arguments for it as well. But intellectually, I'm not convinced it's accurate. And historically, I'm certainly not convinced it's accurate. So the United States Treasury is in a different position in how it may be applied in a portfolio. Do we still want to own boring bonds as dry powder, as principal protection? I think that's all legitimate. But I think that the expectation one has of how asset allocation functions, we're living in a time where the principal must be held dear and the application must be continually thought through. Not because we're radical revolutionaries seeing evolution in

financial markets at every turn, because I'm the opposite of that. I have a constrained vision for financial markets. But right now, whether it's Russia, Ukraine, or the very next thing that will inevitably be around the corner on this side of glory, I think that's incumbent upon us to constantly look for the right application to the principles we hold dear. That's what we're here to do at the Bonson Group. I hope this has been helpful, informative, or at least thought-provoking to some degree. And I certainly invite your questions and feedback. I would love for you to rate us, subscribe, get this podcast in your player, and forward it to those who you think would be of interest. I'll leave it there. Thank you, as always, for listening to and watching the Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, and with Hightower Advisors LLC, a registered investment advisor with the SEC.

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