Is Diversification Dead?


If stocks zig. bonds zag.

This means that, if the stock market goes down, bonds go up.

It’s common to diversify your portfolio by balancing out stocks and bonds, as they historically compliment each other.

But this doesn’t seem to be the case right now. Both are going down.

And people are starting to question diversification as a strategy.

In today’s episode, you’ll get a report on what is going on in the market right now, and how you can still use bonds to build and protect your wealth in 2023.

Listen now.

Show highlights include:

  • The “Recipe” method to never worry about your investment portfolio again ([2:52])
  • What you can ask your financial advisor to understand your portfolio better right away ([7:05])
  • The reason why stocks and bonds are going down together right now (and why this is only temporary) ([7:58])
  • Why bonds are a lucrative investment (even if they may burden your portfolio right now) ([15:48])

DLP067 - Is diversification dead?


Do you want a wealthy retirement without worrying about money? Welcome to “Retire in Texas”, where you will discover how to enjoy your faith, your family, and your freedom in the State of Texas—and, now, here’s your host, financial advisor, author, and all-around good Texan, Darryl Lyons.

Darryl: Hey, this is Darryl Lyons, CEO and co-founder of PAX Financial Group, and you’re listening to Retire in Texas. Thank you for tuning in today.

I always have to give you the disclosures that this information is general in nature only. It’s not intended to provide specific tax or legal advice. Visit PAXFinancialGroup.com for more information. Always, if you need to speak with an advisor, there’s a 15-minute consultation that doesn’t cost you anything. You just need to text the word “TEXAS” to 74868. That’s “TEXAS” to 74868. [00:58].7] 

Today, I’m going to do a show solo and the reason being is that a lot of people have asked for a little bit of a market update, and I don’t do a lot of market updates because I want the content of our podcast to be evergreen, and evergreen means that you can go back and listen to an episode and it’s relatable years later, whereas today’s show will have a certain lifetime value, or it will eventually die, because this information today is going to be relevant for the month of March, maybe April 2023, and after that, economics will change.

I’m going to kind of give a little bit of the state of the economy, but the way I’d like to posture this conversation is I’d like to talk specifically in ways that would be helpful to you. When you turn on the news and they talk about the economy, sometimes it’s hard to understand, how does that really affect me? So, I’m hoping that at the end of this conversation today, you’ll have an understanding of what’s going on in the economy and how that affects you. And it will give you some questions to ask your financial advisor, and so maybe go back and write these questions down or you just memorize them, but I’ll express the questions to ask your financial advisor throughout the show. [02:11].4]

The way I’ll construct it is I’m going to talk a lot about bonds in this particular show. I’ll do another one on stocks, but the reason I want to cover bonds is because, when we talk about Retire in Texas, many people listening the show, I have a lot of young listeners that have reached out and I appreciate that because they’re getting wisdom from the older guests that have been there and done that, but those that are nearing retirement or in retirement, a good chunk of their wealth is in bonds, and, oftentimes, that dialogue doesn’t take place where we actually critically examine the bond part of our portfolio, so we’re going to do that today.

Now, in contexts years ago, we used to talk about balanced portfolios, and when talking about balance, you usually think of a seesaw and there’s an equal weight on the side of those seesaws to make it balance, and one side would be stocks and one side would be bonds, and they’re balanced. [03:07].6]

But what happened over the last decade or so is that bonds weren’t yielding a lot. I mean, neither were your bank CDs. Neither were money markets. Bonds weren’t yielding a lot either. The balance kind of shifted and became unbalanced to where most people found themselves in a portfolio that was 60/40. You might have heard that term before, 60/40 portfolio, and what that means is that 60% of your investments were in stocks and 40% were in bonds.

This is really, really important for you to understand, because we sometimes get distracted by some of the details. If I were to describe your 60/40 as the recipe, many times we get distracted in the details, which is how much do we have in maybe the energy sector, like how much oil and gas companies do we have? How much in Facebook do we have? In Google? Those conversations are very interesting. [04:03].2]

But when you look at the research, the research clearly says that the ingredients, the Googles or how much in technology and how much oil, although it’s important and it has a role, its impact on your wealth is very minor, very minor compared to the recipe. Let me say that, again, the ingredients have some impact, don’t get me wrong, but not to the degree of the recipe. So, I really want you to understand that when you have a dialogue with your adviser that getting that recipe right is really important.

Most people have a 60/40 recipe, 60% stocks, 40% bonds, and we’ve seen over the years several people move to 70% stocks, and I have a client that recently—and this happens to all of us, and so I’m not frustrated with anybody. This is the world that advisors live in—when the market was going up, maybe in 2020, 2019, we were at 60/40, but there was frustration that the portfolio wasn’t able to keep up with the stock market. [05:12].5]

The clients would see the stock market go up 10%, and their portfolio would go up 6%, right, because it has 60% stocks, so that math works. They’re like, Man, I am not seeing it go up as much. And after a lot of dialogue, try to help the client understand. “Hey, we’ve got to understand that you have 60%, 60/40, you have 60% stocks. You’re not going to get all of the stock market growth.”

After a little while, the client, they control their money—it’s their money, we’re the guide on this—but they said, Look, I’m just tired of it, I want to get more growth. Okay, so we shift to 70, and then they’re still like, Ah, I’m still not content, I’m still not getting the growth I want. So, we go to 80%, and the thing about this thing that happens, and it happens almost a hundred percent of the time, by the time we move to 80%, then the market course corrects and it goes down. So, now what happens? Now we’re capturing all the downside of the market because we were chasing returns. [06:10].8]

So, getting that recipe of 60/40 is so important, but also sticking with it over different market cycles is important. I’ll come back to market cycles in a little bit, but I want to make sure that you understand that 60/40. I know I’m over emphasizing that 60/40, it’s getting that right.

By the way, don’t misunderstand, yours doesn’t have to be 60/40. It can be [70:30], it can be [50:50], but, historically, a lot of clients in the marketplace had been 60/40 because that seesaw balance wasn’t working because bonds were yielding enough, and so we had to add a little bit more stocks to boost returns, which worked for many years.

But the question I think really important is, last year, 2022, Morningstar, it’s just a lot of different firms wrote articles on how 60/40 is dead because so many people have 60/40 in their portfolio, how 60/40 is dead. Now, you’re asking yourself right now, “I wonder if mine is 60/40,” and here’s what I want you to do. I want you to ask your advisor, “Is my portfolio 60/40?” [07:15].4]

If they say, “What is that?” first of all, that would be a little bit strange, they should know what a 60/40 portfolio is. Maybe they did. Maybe. I’ll give him the benefit of the doubt. Maybe they misunderstood. Maybe they’re thinking of something else. But ask your advisors, “Is my portfolio 60/40? Why, or why not?”

I think there could be rational conclusions. “Hey, we did a litmus test on your risk tolerance and that’s beyond what you’re comfortable with, so we have more bonds.” Or, “Your plan is designed in such a way that that’s the most risk that we want. We don’t want to take on more risk.” Just ask, but have that framework about the 60/40 and say, “That’s how I understand that most people are building out their portfolios. What makes mine different? Or should I stick with 60/40?” [07:57].5]

But a lot of people started questioning the value of a 60/40 in 2022, and the reason that they wanted to start to question the value of a 60/40 portfolio and they asked the question, “Is diversification dead? Is diversification dead?” Dave Ramsey, he always says money is like manure. It can stink sometimes, but when you spread it around, it makes things grow. I think I got that right. And diversification means you’re spreading it around in different things, but from the high levels, who were just diversifying 60% stocks, 40% bonds, which is very healthy diversification, but it is diversification.

So, a lot of people asked last year, in 2022, “Is diversification dead? Is the 60/40 portfolio dead?” because what happened in 2022 hasn’t– I may be wrong on this and I could double check my research. I don’t think it’s ever happened before. I know it hasn’t happened since 2008, and I’ll have to go back and look and see if it’s ever happened to this degree, but stocks fell and bonds fell. But it wasn’t just the fact they fell. It was the magnitude of the fall. [09:11].5]

Now, in an ideal world, when stocks zig, bonds zag, and so when the market goes down, the bonds go up. That’s the ideal scenario. The understanding behind that is that—and I’m going to get into the Federal Reserve in just a second because I want you to understand that, so we will talk about that. I’m hoping we’ll cover that in this episode. I might have to do a follow-up—but what happens, the reason that truth exists is because, when stocks go down, the idea is that we’re in somewhat of a recessionary environment, so companies are having trouble earning money, and so stock prices are going down, people are concerned. [09:57].5]

So, the Federal Reserve then loosens up the environment for more money to flow by lowering rates. Sometimes there’s policy done by our administration, by Congress, that will lower taxes, but many times, the Federal Reserve will lower rates to spur along the economy. And when they do that, that is a bump for stocks, because when rates go down, that’s above for bonds, because when rates go down, bond prices go up.

Okay, so a little summary, just make sure you hear me loud and clear, and I was clear. When there’s a recession and stocks go down, the Federal Reserve generally lowers rates, and when rates go down, historically, bonds go up, okay? And that’s why they zig and zag together. But what happened last year, 2022, the stock market fell and the Federal Reserve was raising rates. They were raising rates, and they raised it– [11:00].6]

Here’s the thing, and I do want you to understand how the Federal Reserve works, but I want to make sure I’ve got some greater points to cover relative to your stuff. When the Federal Reserve raised rates, I mean, they raised it from 0%, I mean, basically free money out there. Everyone’s mortgage was, like, at 2.5%, right? They raised it all the way to 5%. I mean, they’re going to 5%. Maybe even higher 5%.

Now, that dramatic increase in rate bumps, when rates go up, bond prices go down. When rates go up, bond prices go down. So, 2022, I’m actually referencing a Morningstar index. There’s a lot of indices. An index is a basket of stocks that aren’t actively traded. But the Morningstar U.S. Market Index fell 19% in 2022. That’s a basket of stocks, they fell 19%, and the bond index fell almost 13%, 12.9%. [12:03].0]

So, if you had a 60/40 portfolio, you lost 20% on your stock portion. Your bond portion was supposed to, in theory, go up maybe 4% or 5%. But it also, I’ll say, crashed, for lack of a better word. If you look at that combination in a 60/40, 60% stocks, 40% [bonds], and you had 60/40, your portfolio fell about 15% in 2022, and that’s just not normal.

That’s just not normal. That combination of stock and bond pain just doesn’t happen all the time. In an environment when the Federal Reserve is raising rates, you’re going to see pressure from bonds. I guess what we’ve got to get at is, how do we navigate this in 2023? We still have the Federal Reserve raising interest rates, and so do we adjust our bond portfolios now? [13:08].4]

I think it’s important to know how bonds work because we don’t want to repeat 2022. The stock side of our portfolio we’ll talk about later, but you hear a lot about the stock side. I really want to make sure you know the bond side, because the bond side is a huge part of everyone’s portfolio that we don’t talk about enough. So, how do we look at bonds going into 2023?

The Federal Reserve still has intent of raising rates to curtail inflation and what they’re fighting against, the Federal Reserve is fighting against the housing market that’s still hot. I mean, Texas in the last five years—Texas does mirror the national economy—the 5-year change in housing prices is, I mean, 60%. Basically, everyone made 60% on their home in the last five years. I mean, just crazy. [14:00].0]

The housing market is a good catalyst for growth all the way around, because Home Depot obviously does well in that environment, or Family Leisure or whoever else, Walmart. All these companies, when somebody buys a new home, they do stuff in the stores, and so it really just spurs the entire economic system.

The problem that the Federal Reserve is dealing with is that they’re dealing with this inflation that was up at 9%. It started to level off a little bit. Some people believe it’s plateaued, but they’re trying to target it down to 2% inflation, and to get it to 2% inflation, they’ve got a slow this roaring, roaring housing market, and they keep notching up the rates, but the housing market continues to roll. Why does it continue to roll? Because there’s a lot of people that want houses and there’s not a lot of houses.

There’s a lot of people that want houses and there’s not a lot of houses, and so in economics, we call that a supply-demand imbalance. When you have a supply-demand imbalance, the Federal Reserve is saying, “How do we slow this thing down? How do we keep from these housing prices continuing to go up? They’re fighting this. [15:06].4]

When they raise interest rates, it’s designed to slow the housing market and the business market, because it makes it challenging to lend. The banks have restrictions on lending and then it’s a higher rate, so that discourages lending. The Federal Reserve is really trying to slow this market. They’re doing their best. I mean, I think of the Federal Reserve as, simply, they have two pedals. They have the gas pedal and the brake pedal. The gas pedal is they lower rates, press on the gas, but right now they’re pressing on the brakes, which is they’re raising rates. So, they’re raising rates to slow down this economy. They still have more room to work.

Why does this impact bonds? And why is this important to you? Let me explain a bond. I mean, is that okay? I just need to just spend a minute just explaining a bond. A bond is a loan. [15:59].7]

You make a loan to Ford and Ford says, “Okay, thanks for lending us this money. We need to put in a new manufacturing plant somewhere and we need the capital to do it, so thank you for lending us the money. We’re going to pay you back in 10 years and we’re going to pay you 2%.” Maybe 3%, okay? This was a couple years ago. You’re like, Okay, I’ll take it, Ford is good for it. I trust them. I like their F-150s.

They’re paying you interest. You get it every six months in your portfolio. Then the Federal Reserve raises interest rates and it kind of trickles over to Ford. Now Ford is issuing new bonds in 2023, and now they’re issuing these bonds at, I’ll just make this up, 5%, and you already have the old bond of Ford at 2%. You already have that one, but now you want the 5%, so you go out and you get the 5%. But you’re like, You know what? I don’t want my 2% anymore. I just want a bunch of 5%.

So, you go to the market and you go, “Hey, market.” That’s not how it works, but just bear with me. “Hey, market, and I want to sell my bond.” The bond that you lent, so you lent the money to Ford, you lent them, I’ll say, $10,000, and Ford in these promises between bonds, they pay you back at the end of the term, your $10,000. You lent them $10,000 in that first transaction and they gave you 2%. At the end of 10 years, they give you $10,000 back. [17:15].5]

So, you go to the market and say, “Market, hey, I don’t want these 2-percents anymore because Ford is giving me 5-percents.” You go, “Hey, market, I want to get rid of my bond. I want to get the good stuff now.” The market says, “Uh, we want the good stuff, too, but we’ll take your bond. We just want to give you 10,000. We’ll give you 8,000.” And you’re like, What? I paid 10,000 for this thing. I’m going to get …

Ford is still going to pay you back 10,000. There’s no doubt about that, that contract is still in place. But the market looks at your bond and says, “I just don’t like it as much because I get 5% over here.” Are you picking up what I’m dropping? Your bond just went down in value. That’s what happens when interest rates go up. Your bonds go down. When interest rates go up, bonds go down just like that. [18:02].4]

Now, the interesting thing about bonds is that if you hold them to maturity, you still get your money back. That’s the kind of thing that we don’t think about. It’s like, even if my bonds went down because interest rates go up, there’s still a contract between these companies, as long as they stay solvent, and we don’t have any solvency issues right now and in the marketplace. We might have some in the municipal sectors. Actually, there are surpluses in a lot of the municipalities so we don’t have really major threats in the municipalities, but no real solvency issues. But the bond prices went down. It doesn’t mean that the agreements between all the companies and you have changed. They’re still going to pay you back at the end of the terms, but on paper, the value of your bonds are worth less. I hope that makes sense. It’s hard to translate that without a whiteboard sometimes, but I hope I did my best in helping you understand it through these airwaves. [18:57].3]

So, what does that mean on the 2023? It does mean that we still have some threats on bonds, still, coming into this year, but you’re actually getting paid on bonds. As long as you’re comfortable just going through the volatility, right now, bonds, you just go to Bankrate.com and look at CD rates right now and you’re seeing money markets and CDs paying 3%, 4%, 5%. Bonds are always going to be ahead of that because the risk profile is different. So, we’re looking at bonds in the marketplace 4%, 5%, 7%, 11%, I mean, across the board. Depending on the type of risk, bonds are wonderful this year, and I haven’t had fun with bonds, by the way, since 1999 when I first got in this business. I’m having so much fun in the bond market this year.

So, our 60/40 doesn’t feel as though it’s in despair anymore because that bond portion is actually getting some nice yield. Yeah, there’s still a degree of pressure that could exist, but at least we’re getting paid some nice interest along the way. A good mutual fund manager, a good manager is going to find some good bonds in this market and, hopefully, improve yields. I am utterly convinced that a 60/40 portfolio and diversification will win out over time. [20:10].8]

I’ve been doing this long enough that I think Mark Twain said it best. Mark Twain said everything, and I guess he said this. Maybe he picked it up from somebody else, but he says, “History doesn’t repeat itself, but it often rhymes.” So, I say when you come after a bad year chasing returns and maybe trying to do something dramatically different and saying, “Yeah, that 60/40, that doesn’t work anymore. I’m going to abandon it and chase another strategy that might have worked in 2022,” that usually hurts people.

I have found that just being rational, cerebral, thinking long term, just understanding the scope of what we’re dealing with and sticking with the strategy usually bodes well the following year. And you know what? This one might take 12 to 18 months, I’ve got to tell you, because the Federal Reserve, you can see the forecast of how long it’s going to take for them to raise rates, and then you also have that debt ceiling coming up. I’ll actually talk about that in our next show. But this little volatility may take 12 to 18 months, but it’s my conviction that diversification will play out. [21:13].6]

I do think it’s a good idea to double-check with your advisor, ask them if you’re in a 60/40. Visit your plan and say, “Should I still be in 60/40 or do I need to tweak it, maybe make a shift to 50/50 or flip it 40/60, maybe 70/30, 80/20?” That decision is actually way more important than how much Exxon you have. So, get that right, and then, of course, you can get into some of the weeds and how much Exxon do you want. There’s crypto, whatever. There’s some peripheral things that you can do.

I’m looking at my time, and I’m already out. I’m going to do another show right after this one next week. In this one, we’re going to go into the stock portion of the 60/40 and some questions to ask your advisor about the stock portion. But thanks for hanging with me. [21:58].5]

Bonds are just not fun, but I think this might be a fun time for those people that are paying attention to bonds. If you’re paying attention to bonds, I think you could be rewarded over the next five years, really, a long-term time horizon. I think this could be a great inflection point for those people who are paying attention to what’s going on in the bond market.

Thanks for hanging with me on this bond podcast and the 60/40 podcast. Remember to text the word “TEXAS” to 74868. Connect with your financial advisor. And I want to remind you, as always, you think different when you think long term. Have a great day.

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Don’t Lose Faith in the 60/40 Portfolio.  https://www.morningstar.com/articles/1133395/dont-lose-faith-in-the-6040-portfolio

Texas Housing Market Predictions & Trends 2023  https://www.noradarealestate.com/blog/texas-housing-market/

Factbox: The U.S. debt ceiling and markets: Gauging the fallout  https://www.reuters.com/markets/us/us-debt-ceiling-markets-gauging-fallout-2023-02-16/

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