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Diversification has a Globalization Problem
Bitcoin doesn't fix this, but Defi does
You shouldn’t put all your eggs in one basket. The idiom is attributed to Cervantes in Don Quixote, where the phrase reads:
[…] ’is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.
It’s easy to understand its enduring appeal. We visualize someone (a farmer?), walking with a basket full of eggs. He trips and all the eggs break.
Is it just one basket?
You could apply the egg and basket analogy to single stocks. Don’t buy just one (or two) - purchase many.
But if you’ve watched stocks recently, they don’t look like separate baskets.
The example above is for US stocks. Could that be the reason?
Unfortunately, the lack of geographical diversification is not the only problem. A recent research shows that a geographically diversified portfolio wouldn’t help much.
Even as investors have greater access to distant frontier markets as well as all manner of developed and developing stock indices, the benefits of diversifying their equity allocations among them has diminished.
You could also diversify with a basket for stocks and one for bonds. But, as Central Banks look set to reverse 14 years of loose monetary policy, bond prices will likely fall further.
Diversification is a dynamic exercise
But wait, we now have new asset classes, like Crypto and Bitcoin in particular. Bitcoin is inherently different from stocks.
If we’re talking about crypto tokens associated with specific projects, you could say that they are similar to startups and could behave similarly to equities. Bitcoin does not represent a group of people pulling together to create and market a product or service.
And indeed, Bitcoin used to offer diversification benefits a year ago when we didn’t need it or want it.
In May 2021, the S&P 500 was making new heights while Bitcoin had dropped by almost 50%, from over $60,000 to mid $30,000. Its realized correlation with the S&P 500 was negative. Now the correlation is at around 75%.
Bitcoin has gone from a great diversifier to behaving like a stock index in one year. The chart above shows the dynamic nature of diversification. My guess is the dynamic is similar to what happened with stock indices. As investors have greater access to cryptocurrencies, they will tend to behave increasingly like other asset classes.
But if diversification is dynamic, you can say goodbye to strategic asset allocation, which is why it makes it “the ugliest chart”.
It’s tricky for alternative assets
The classical pitch for private equity, hedge funds and other “alts”, which we’ve covered before, is:
Above equity returns
Decorrelation / Diversification
Here’s a recent email from Securitize.io, a startup “Unlocking broader access to alternative investments.”
Alternatives tend to have a low correlation with traditional asset classes. They can be key to a diversified portfolio and are typically unaffected by market turbulence, making them powerful risk management instruments. Of course, there is no guarantee that a diversified portfolio will prevent against loss. Unlike traditional investment products, they’re less dependent on general market trends and are more influenced by the inherent strength of each investment.
There’s a window of opportunity for Alts marketers like Securitize. Investors tend to think about diversifying in a downturn when they need it, not before.
And there’s a significant risk for investors, particularly for illiquid assets where price discovery is delayed: if prices appear stable, are the assets' strategically decorrelated’?Or are they about to fall, and you’re buying the top?
The image that comes to mind is Coyote, who runs over a cliff, and then keeps running but falls when he looks down.
Then announced significant losses a month later:
It doesn’t look like the new investors will benefit from lower-priced acquisitions.
Yet even that new fund — which reportedly took less than six months to raise and includes $1.5 billion in commitments from Tiger Global’s own employees — is almost fully invested already, according to a source close to the firm. (Source)
It’s as if there’s only one basket for investors.
Or going back to the farmer, maybe he carries 2-3 baskets, but if he trips, they all drop on the ground and the eggs break anyway. So holding assets may not be enough.
How to diversify or hedge?
First, let’s take a measured approach. The reality is more grey.
Not everything is crashing. For example:
Commodities are on the rise
Real estate seems to be holding well
Some equities are doing ok (I just spotted in my portfolio the decent performance of an ETF tracking Asia-Pacific ex-Japan)
And there are tools to hedge or sail through the storm:
You can buy puts or sell futures - even on retail investing platforms
Just keep buying, says Nick Maggiulli
It’s ok to hold cash, even if it has a negative net return due to inflation (better than equities).
Another approach is to generate yield by utilizing the assets and putting them to work. It works with real assets.
If you own a piece of real estate and the market crashes, it’s pretty easy (assuming you don’t have urgent capital requirements). Don’t sell now. Rent instead!
Being a landlord can be labour intensive, but rents are great if you look at it from a diversification point of view. If you have negative cash flows from buying and selling assets at a loss, then the positive flows of rental income are inversely correlated! (In the long run, they will decrease if property prices fall, but they’re still negatively correlated with falling prices).
It’s technically possible to rent or use financial assets, but it isn’t straightforward:
Lend your stocks? (apparently, you can, with Sharegain)
Transform your commodities? Make jewellery from your gold and refine your oil?
Being able to use assets and not just buy and sell them, is great for your portfolio.
Defi: where financial assets have utility
Defi stands for Decentralized Finance. There are few or any truly decentralized projects in practice, but we’ll stick to the term for anything that happens on-chain. I believe it can be a game-changer for investors.
You can buy and sell assets (tokens). But what brings Defi closer to real assets is that you can easily:
lend & borrow
use the assets: by providing liquidity, staking, or being active in the governance
The process is simple: through a software wallet.
It’s accessible: if you use an L2 chain or a chain like Solana, the transaction costs are typically a few cents. (On the Ethereum chain, they generally are in double figures, making it prohibitive for most investors).
The yields are typically higher, reflecting the ecosystem's risk and capital requirements. But it compares well with high yield, which is roughly 5% and a risk of default of
Combining all the above makes it possible to generate yields that are not correlated to other assets. It’s not theory. I’ve been practising with my investments. I call it “Defi like a Dad”: finding boringly steady yields & conservative crypto investments.
I’m putting together a library with non-directional Defi strategies but I’m not sure if there’s demand for this type of content. It could be an online course, but I am not sure, yet. If you want to find out more or get updates (sign up here, it’s free).
Other stuff that may interest you:
The podcast discusses the disruption of fixed income investing, a $120 trillion asset class that doesn’t get much love.
Talking about Tiger Global: do you think Axe Capital from Billions should follow their example?
If you want to know why Elon Musk will not overpay for Twitter, check this playlist.