It has been my experience when reviewing portfolios that diversification is typically expressed simply as a number of various stocks owned, or owning a handful of asset classes, usually stocks of various sizes and geographies, and bonds of varying maturities. While such a simple asset allocation may work for many investors, it is my view that too little thought is given to other diversification tools that may enhance a portfolio by addressing some vulnerabilities that can result when a portfolio is inadvertently too heavily weighted, for example, toward one factor, or a benign macroeconomic environment such as low and stable inflation.
Here below are a few simple diversification strategies that I think enhance a portfolio’s resilience through market and economic turbulence:
I. Beware Factor Concentration
You don’t have to be a stock picker to find yourself overweighted a given factor; the current stock market structure in the U.S. as measured by the S&P 500 or the MSCI USA indices is heavily weighted toward technology issues, with that sector alone comprising more than 30% of the index’s weighting. What’s more, if you consult Professor Ken French’s database, which has not been as arbitrary, I would argue, with sector categorization as the major index providers, you will find that the unadjusted (see here for details) technology weighting in the U.S. market is closer to 40%, higher than the tech bubble peak weighting. On the other hand, the non-durables sector, which contains classically defensive industries such as tobacco and beverages, now constitutes barely 3% of the U.S. market:
From a factor standpoint, this matters because as MSCI demonstrates in their index literature, information technology is more heavily loaded on the momentum factor, and heavily negatively loaded on the low volatility factor, thus making a generic index fund more exposed than an investor intends (source – MSCI):
Conversely, consumer staples (another term for non-durables), tend to be more neutral as it relates to momentum loading, but heavily loaded on low volatility (source – MSCI):
These differing factor exposures make the two sectors nice complements in a diversified portfolio, as illustrated by their heavily negative correlation with each other. In sum, if you are concerned that your index fund or your portfolio’s heavy tech exposure leaves you too exposed from a factor perspective, – momentum has tended to sharper and longer drawdowns, historically, – , an allocation to consumer staples may be useful in a barbell approach, which we explored previously here.
II. Gold As A Complement to Fixed Income
Before you roll your eyes at the mention of gold, please allow me to explain. Gold is unique in its lack of correlation to major asset classes, it is not beholden to any central bank action, and it is universally liquid. Because of these qualities, it has tended to be a safe haven during periods of global turmoil (source – State Street):
Gold, unlike a lot of fixed income such as intermediate- and long-term bonds, has also proven useful during inflation periods such as the last few years. This is because correlations between stocks and bonds tend to rise during inflationary periods, thus rendering traditional fixed income less useful as a portfolio diversifier than it typically is when inflation is low and stable. Inflation shortens investors’ time horizons, so low- and no-duration assets such as Treasury bills and gold tend to come into favor with investors. For example, since the end of 2020, a period of higher inflation, long-term bonds languished, TIPs broke even, and Treasury bills outperformed both:
Gold, as measured by the SPDR Gold Trust, handily outperformed Treasury bills, perhaps because it has theoretically unlimited upside, whereas bills are limited in upside based on their defined maturity. Of course, gold skeptics will say, stocks continued to do well despite inflation, and that is obviously true, so why do investors need gold exposure? To be sure, I do not disagree entirely: stocks are real assets that can pass on costs to consumers, and as such, they have historically been the best hedge against long-term erosion in purchasing power.
It is not my contention that investors should consider supplementing their equity allocation with gold, but rather I argue an investor’s fixed income allocation could stand to benefit from such an allocation, especially in an era with heavy government indebtedness, noisy inflation, and periodic economic turmoil. Investment success over the long-run depends on surviving periodic short-term liquidity crunches, and given fixed-income’s vulnerability to inflationary pressures, gold has proven its utility as a diversification tool.*
*An entirely separate discussion is how best to obtain exposure to gold; I tend to favor royalty and streaming companies, but that is a topic for a future post.
III. Diversify Your End Revenue Sources
One of the least discussed secular growth trends is the growth in government spending; the federal government is currently spending trillions annually, running deficits that are the largest in a non-recessionary, peace-time world:
How can investors use this profligacy to their advantage?
For one, government spending tends to be steady and predictable, and often counter-cyclical; it is one of the main reasons that defense primes, for example, have been one of the few industries to score a higher risk-adjusted return than the market over the long-term, and have yet to record a ten-year period of negative total returns. This characteristic of being almost consumer staple-like is a major reason that defense companies tend to outperform during market downturns. Witness the performance of Lockheed Martin versus broad industrials during the 2007 – 2009 financial crisis, and the COVID crisis of 2020: 
Another example would be government spending on policing and public safety. Since 1959, state and local spending on this category has grown consistently and without interruption, compounding at around 5.75% per year without a year-over-year decline in spending, not even during the financial crisis of 2007 – 2009 when many municipal budgets were stretched to the breaking point:
Because of this relative lack of uncertainty regarding revenue projections, government spending beneficiaries across the spectrum, – software, defense, law enforcement, etc., – tend to exhibit lower betas than the market and their peers, making them useful portfolio diversifiers:
Of course, each investor should take into consideration his or her own unique situation, goals, and resources in order to determine what is the best asset allocation for him or her, but I hope these ideas offer some food for thought for those examining their portfolios after a long bull market and looking for additional ways to diversify their nestegg.
Disclosure: At time of publication, both the author and clients of Fortune Financial Advisors, LLC, own shares of Lockheed Martin and Booz Allen Hamilton. Clients of Fortune Financial Advisors, LLC, own shares of Tyler Technologies and AXON Enterprises.
