Warning: This chapter is going to help you realize something that may leave you deeply troubled.
What you are about to discover will mean all that debt you paid off for your college education and all those commissions you paid to your financial advisors was money spent based on a theory of investing that has been proven completely false!
You were told from a young age, brainwashed, mind you, that as you accrue wealth and invest that you should follow a diversified portfolio approach to asset allocation. In simple terms, this means diversifying your investments into areas like bonds, stocks, real estate, forex and commodities. The idea is based on having money in low or non-correlated investments, so that if your real estate holdings dip, then another area of your portfolio will be relatively unaffected.
Your advisor might have even gone so far as to explain that some of those investments have a negative (opposite) correlation, so that as one investment loses, the other gains (stocks and bonds). This is a critical point of discussion because, if this theory is in fact not true, then you are investing under the belief that your investments are at a lower risk than they really are.
In the 2008 market crash we all were reminded (and this wasn’t the first time) that all these markets, and the markets within the markets, are in fact tied together. And in some instances that inverse correlation reverses and becomes directly correlated.
Somewhere along the path that led you to this book you may have heard or seen me talk about “Zero Correlation” investing. Whatever you do, don’t confuse this term with the old adage used by countless financial advisors called “Portfolio Asset Diversification,” or more commonly “Diversified Portfolio.” These terms are not the same thing as zero correlation. In fact, they are used to imply a sense of risk reduction through spreading your investments around, but in no way do those terms mean or suggest that those so-called diversified investments are not correlated. And by correlated I mean that, during certain times and events, the treasuries, futures, gold, oil, stocks, forex, ETFs, REITs, property holdings and bitcoin investments all have underlying connections that tie them together in some capacity. These events are often times of crisis, when volatility is at its peak and the markets are moving so fast most investors can only be bystanders looking at the destruction.
The real problem with asset diversification isn’t that it no longer works at all, but that people expect that it will always work. And that’s just not true because even sophisticated asset allocations can’t guarantee you won’t lose money in a lousy market.
In reality, that battlecry from your broker or advisor that claims your diversified portfolio is low risk is really just smoke and mirrors to make you more comfortable risking your hard earned capital. Or, if we are being honest, many of us have what I like to call “Mighty Investor Syndrome” where we know certain truths, but refuse to acknowledge them. We know that all of these things have underlying connections, or at least we assume them do, yet we plow forward hoping and praying another crash won’t come until we have made our billions. Wealth and the constant chase for more can often times make us delusional.
Unfortunately, I was no different than anyone else that was sucked into the theory of portfolio diversification, only to get wiped out of years of accrued wealth. While I promised myself I would never end up in that situation again, it is worth revisiting as a lesson to others.
I truly believe that, at the end of the day, we are all really looking for the same thing; the “perfect investment” and someplace we can invest our money with little or no risk and just watch it grow, day after day, month after month. Then, to make it really perfect, we can pat ourselves on the back afterwards because we knew it was going to happen. That is why I call it the “Mighty Investor Syndrome.”
The reality, of course, is that this kind of investment is next to impossible to find in one single investment, especially when you are looking for limited risk and high rewards. Not surprisingly, people spend a lot of time developing methods and strategies that they feel come close to the perfect investment portfolio.
If you were to craft the perfect investment, you would probably want its attributes to include a high yield and low downside. However, if you were trying to put together the perfect portfolio, rather than an individual investment, then you would add onto that list the least amount of correlation possible. And there is that word again: correlation.
2008 taught us a lesson that no matter how much we try to diversify, it’s almost impossible to have investments that are not connected. As much as people have tried over the last few years to make us forget, we now know that when it all comes crashing down, and it will again someday, that everything will be connected in some way.
What exactly is correlation?
Well, we have used that word enough, so maybe we should define it, in case there are some investing newbies out there. Correlation is a measure of how two assets move in relation to one another. This can be anything from one stock versus another stock, to property, to even investing in a candy store. It’s basically the connection between two assets and how that connection relates to each asset’s value.
In the investment world, this measure is known as the “correlation coefficient,” and each asset will be assigned a number that will fall between 1 or -1. If two assets have a correlation of 1, they move perfectly in sync with one another. If the correlation is -1 they move in the opposite direction, whilst a correlation of 0 means there is no relationship. Again, we call this Zero Correlation.
So let’s start with positive correlation. Stocks in the same industry would have a high positive correlation because they would probably be affected similarly by events. Owning shares of IBM and Apple would put you in a bad situation if China suddenly raises the price of microchips or the government added new regulations on tech that stifle growth.
Negative correlation is achieved when two or more investments move inversely or opposite to each other and create a negative correlation. Theoretically, two assets that work perfectly in this way would eliminate the risk of the combined assets.
A common example is the negative correlation between oil prices and airline stock prices. Jet fuel, which is made from oil, has a significant impact on the profitability and earnings of airlines because of the obvious cost factor. If the price of oil spikes, it could have a negative impact on airlines’ earnings which would drive the price of their stocks down. But if the price of oil trends downward, the airline’s profits would increase and therefore their stock prices would rise.
This airline vs oil price example is fairly textbook, and by textbook I mean you would actually see this in a textbook explaining inverse correlation. Ironically, this is exactly the false perception of inverse correlation we were taught and our financial advisors were trained to preach. It doesn’t take a genius to realize that there are other factors at play.
An airline might have hedged fuel prices in the futures market and locked in costs, so that price action in oil doesn’t impact their profitability, for example. There are so many aspects to what goes into the price action in a given stock that to broadly state there is an inverse correlation is a fool’s notion.
Zero Correlation, on the other hand, is when your assets show no relationship at all to each other. Combining multiple assets like this would be an ideal diversified portfolio because the risk (volatility) of the portfolio would theoretically be reduced.
Now comes the bad news. In the real world most traditional assets and investments have some sort of correlation. Owning shares in stock, investing in my own business and then purchasing property is the strategy I used prior to the big crash and it didn’t help me much. In fact, it was the reason for my downfall.
When the housing bubble popped, the stock market wasn’t far behind and then the national, regional and local economies. As the clientele of my brick and mortar businesses began to feel the economic pressure, my businesses began to falter. If not for a quick pivot I would have lost absolutely everything. As it was, I barely made it out alive.
One of the problems I have identified since then is that most investors are doing the same thing the exact same way, which is why I decided to break that trend. ScoreMetrics is my answer to the age old question; “what truly has zero correlation?”
So, you see, when I say that we have been lied to our whole lives about these things I am not just saying that. I preach this daily and can share my personal stories about my own failures to prove it. I can only promise you and anyone who will listen to this one thing…it will never happen to me again.