Three financial dirty words to diversify portfolios

Nov 15, 2013 @ 12:00 am

Runtime: 4:41

Without access to these three areas, there is no way to escape the stock market dominating your portfolio, saysCliff Asness of AQR Capital Management.

Video Transcript

This week on WealthTrack: A financial thought leader and money manager who says you are not totally diversified until the three dirty words of finance are in your portfolio. AQR Capital's Cliff Asness explains what they are, next on Consuelo Mack WealthTrack. -Three dirty words of finance are leverage, derivatives, and shorting. -Right. -And it's because they're scary. And first let me say, they really are scary. -Yes. -We say-- -Leverage, having debt, is a disaster if you had too much of it during the financial crisis. -Absolutely. Shorting can get you in trouble, certainly, if you concentrated in an individual name. Derivatives, certainly, if you don't understand what you're doing. -Right. -This will be a very general statement, but the worse use for these things, so it's given them their worst name, if you ask me, is twofold. It's levering, and often done with derivatives, and what not, a bad bet to try to make it into more money. And let me give you an example. If I sat here and told you stocks are gonna return less than normal, which I did, someone can come along and say, "Well, I can fix that for you." And let me make the math easy on myself. When I'm on T.V., I can't do math any better than someone who's not a quant. Let's say they're half as good as normal. -Uh huh. -Someone comes along and says I'll just lever it two to one. -Right. -First of all, they're not wrong, they did return. Your expected return has gone up, has doubled. The only problem is, of course, they've also doubled their risk, -Right. That's right. -and that can be a total disaster. And the other dangerous use of these things is obfuscation, particularly in derivatives. I'm not a big regulation guy. That won't surprise you. But I will give people advice that there's no particularly great or pressing need for super complicated derivatives. -Uh huh. -But the basic ones-- -Such as? -Financial futures. -Uh huh. -Short selling an individual stock, which is not a derivative, but it's my third dirty word. -Right. -When these three things are used not to lever up a bad bet, to try to make as much money against the past, not to obfuscate a complicated bet, but to create a new return and risk, and I say both, it's still a risk, that wasn't there before. Long, cheap stocks, with good momentum and good quality characteristics that are defensive. Short their opposite brethren. And that's not an arbitrage. You don't make money all the time. But it's a different risk than the stock market that we believe pays you to do far more often than it doesn't. So when these techniques are used in moderation to diversify more, to make something that would not matter now matter a little bit, then we think they can be a force for good. -The typical diversifiers are, for instance, gold. I mean cash is considered to be a diversifier, you know, limited partnerships. I mean there are REITs that are, you know, considered to be non-correlated. Are there other simpler tools that we should have or investments that we should have in our portfolios, if we can't go that kind of the more sophisticated route? -Sure. You've managed to name four of the many things I consider myself not an expert on. -Uh huh. -But REITs are certainly a possibility. -Right. -We think real assets, in general, should get more play in a portfolio, and the stock market doesn't have enough of them. I would buy a diversified portfolio of REITs. And that could be my expertise. I don't have special expertise. -Right. Right. -I do think cash, even at zero, if you are-- it becomes a timing situation. I do not think people should all run to cash. The risk premiums are still positive. But here is what I would prefer. Some people-- I'll set up a straw man that you didn't ask me about. A lot of people ask me about should I buy "puts" now. Should I go buy insurance against this market that gives you-- -Right, a decline. -I think that is almost always a bad idea, unless your timing is superb. "Puts" are almost an option. -Well, they're short term. You can-- Right. You can lose money on them, and they can be expensive. -They're hugely expensive. You nailed it. -What about just gold as an insurance policy against disaster? -I would own a small amount in almost any portfolio. -Right. -And not a large amount. But gold is true. It's not a bad world. It's a disastrous world insurance. So I would own a small amount of that. I'd own a small amount of REITs. But to be brutally honest, without access to those three dirty words, there's not a whole lot you can do to escape from the stock market dominating your portfolio.

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