Diversification is one of the first things most people learn about investing. The phrase “don’t put all your eggs in one basket” probably sounds familiar.
At its core, diversification means that when we build a portfolio we want to dump in a bunch of different investments with different risk profiles. That way they’re not all likely to fall in value at the same time. They work “together” to reduce risk.
Think of it like baking a cake. Dumping a bunch of flour in a cake pan and tossing it in the oven probably won’t turn out very good. But when you add sugar, milk, and eggs in the proper ratio, you’re a lot more likely to get a desirable result.
Typically, investors accomplish this by investing in two primary assets classes: stocks and bonds. Stocks and bonds are very different animals, which is really the whole point. In most circumstances one goes up when the other tends to go down, and vice versa.
There’s an interesting phenomenon that’s often overlooked when we view our investments this way though. While we like to think that stocks and bonds “work together” to reduce risk, they actually compete against each other in the capital markets. This behavior is a major reason we’ve seen such strong equity returns over the last few years, and will likely help to explain what kind of returns we see over the next 5-10 years & beyond.
This post will dive into this concept, what’s currently driving stock prices, and what’s likely to happen next.
Long term real S&P Composite price index vs. earnings. Source: Robert Shiller’s Online Database: http://www.econ.yale.edu/~shiller/data.htm
Long term CAPE vs. long term U.S. interest rates. Source: Robert Shiller’s Online Database: http://www.econ.yale.edu/~shiller/data.htm