U.S. markets seem at relatively elevated valuations. That may pose a risk to long-term returns. Will diversification rescue your portfolio? Unfortunately, there are reasons to think that bonds, though useful, may not provide the same level of protection they offered in 2008-9. This is because of current low or negative yields and central bank positioning when compared to the late 2000s. So might there be another path to protect your portfolio?
Commodities
Commodities march to the beat of their own drum. That can help diversification. Though for many commodities demand has a link to sectors of the economy, supply movements can be independent of the economic cycle offering some protection. Indeed, a sharp spike in the oil price can even cause economic problems directly. As such, historically owning oil has been a natural hedge to certain economic shocks, most obviously in the 1970s.
There are challenges to owning commodities too though. One main one is that assets like stocks and bonds typically pay you to hold them as an investor whether through a dividend or an interest payment. Commodities don't typically have that benefit, all you get is the change in price of the asset. Often those changes average around zero over time. That's one reason commodities have lagged other investments for the longer term. In fact, you can end up paying a small cost associated with the management and storage of the commodity. Furthermore, commodity Exchange Traded Funds (ETFs) are not cheap in relative terms. You can pay 0.8% a year in expense ratios for some of the more popular commodity ETFs today. Compare that with the 0.1% expense ratios or lower available for lower cost ETFs today and you can see that though commodities may be a desirable asset class, there's a cost drag associated with owning them.
Finally, bear in mind that many large commodity ETFs are dominated by oil and related products. That's not a problem per se, and there's logic behind it has energy commodities have significant volume and liquidity, but it does the diminish the diversification of some commodity funds. The direction of the oil price is likely to inform the direction of the fund. As such it may be worth considering owning certain energy companies, which have exposure to oil, but have a potentially lower cost to own, rather than owning the asset directly. The same trade-off can be considered for owning gold directly relative to owning gold miners. However, by owning companies you reintroduce some of the correlation with stocks that you were looking to diversify away in the first place.
It also comes back to your overview of the economy. If you are worried that inflation will come back, commodities probably make sense for your portfolio. Bonds with historically low yield don't appear to offer much protection against unforeseen inflation today. Commodities could be a better bet.
Put Options
Options trades are not for the uninitiated and can easily get you into trouble if you don't know what you're doing. Still put options in theory offer a perfect hedge for the market. If the asset that you own a put option on falls in value, then you make money. However, unfortunately this is broadly known and a lot of investors seek this protection. As a result put options can be expensive. This means that on average the cost of buying a put option has historically been greater than the expected value it provides. So buy permanently holding put options through the market cycle, you will do better when the market drops and worse when it rallies, but through the cycle you will lose money if history is any guide. Researchers have typically found that the returns to holding put options over any extended period and negative. Own puts and on average, you will typically lose money. That's in contrasts to stocks, where historically just picking up a basic tracker fund for stocks has offered meaningful returns. One might expect to have to pay up for what is essentially insurance for your portfolio, but the cost can be excessive. As such it's fair to assume that put options will deliver during a market crash, but you stand to lose a lot of money if you're waiting a while for that crash to occur.
International And Sector Diversification
We should not ignore that within stocks, international and sector diversification can help. Plus there is evidence that investors exhibit home bias and don't diversify sufficiently. So perhaps for many there is a free lunch here. However, here it depends what sort of event you're looking to manage. On a multi-year view, having broad diversification in your stock holdings can avoid the risk of missing out on a hot market and smooth returns. However, in a market panic, often stocks can tend to move down together and so holding a set of different investments may be somewhat useful, but may not change the performance picture all that much. There are plenty of great reasons to diversify your stock exposure, but expected that move to help your in a market correction may be over optimistic. How much stock diversification helps you really depends on what the next bear market looks like.
Cash
Owning cash via a very short-term, high quality bond ETF or a high-interest saving account is another option. Your interest rate may move over time, but the chances of a major capital gain or loss are generally considered to be low. This is an investment that does pay you money. Today, in the U.S. you can earn somewhere between 2% and 3% with these investments depending on which you pick. The nice thing is that you are paid to hold this investment when compared to commodities and especially put options which have costs to them.
However, cash being stable is a double-edged sword. Yes you won't lose much, but you won't gain much either. So in a bad market, your investment will be safe, but unlike with put options or to a less extent bonds or even commodities there is very little chance of it rising in value. This means that part of your portfolio will be protected, but there is unlikely to be any material gain to offset losses in any stock market crash. Furthermore, cash generally has inferior returns to other assets because of its safety. Therefore, to implement cash as a protection strategy, you would need a plan to move out of cash when markets fall. That's hard for a number of reasons. Moving out of cash into a plummeting market is psychologically tough, even though it may be a smart call. Furthermore, it requires market timing, which even experts have a lot of trouble with. Hence the costs of moving off a buy-and-hold strategy may exceed the potential benefits of waiting around in cash.
Summary
With so many investors looking for the holy grail of a portfolio with equity-like returns but less risk, it should not be surprising that true diversification is hard to find. It seems that the apparently high returns that stocks have historically enjoyed are precisely because at certain points stocks can fall in value by a third or worse and potentially then take years to recover. The outsized returns stocks offer is perhaps compensation for the outsized risks.
Nonetheless, investors should look to diversify by sector and internationally in the first instance, that seems to be about as close to a free lunch as you might get. Then it's clear why bonds are an attractive diversifier since the asset tends to offer both a positive return and a degree of insurance in certain markets. However, bond yields ain't what they used to be. Moving outside of that that commodities can be useful, but can potentially dent returns and you need to be careful you aren't just making a single bet on the oil price. Put options are well engineered in theory, but historically can been a poor long-term asset. Cash is not a terrible short-term choice, but implicitly leads you into a more active investment approach, which can be risky or just puts you in a potentially dud asset class for the long-term. So it seems to make sense to use bonds and diversify your stock exposure, but the reason that portfolios such as a traditional 60/40 stock/bond split are so popular is because most of the other diversification methods do have limitations.
