Lesson #14 – Learning To Use Uncorrelated Assets
The story goes that in Europe it was at one time held that swans were all white. Then people began to “explore” other areas of the world and discovered something they never imagined: black swans. With birds, these sorts of surprises are pleasant. In investing, they usually mean that you’ll lose a lot of money.
For example, Bitcoin recently “crashed” more than 20% and below its 50-day moving average. Should you be concerned?
A follower asked me this in my Quora Space “The Art of The Bubble” just this morning. Now, I have written about scaling out of trades recently, but I haven’t traded out of Bitcoin yet and I’m sleeping well.
The reason is that I built my portfolio to be black swan resistant. Specifically, it addresses the following questions: Can you ever develop a strategy that can anticipate what you won’t anticipate? Can you make it do well regardless of the unexpected?
My answer is that you can through two specific strategies: intelligent diversification and the art of hedging.
Combined these strategies will do two things for you.
- You’ll be better positioned to keep your hard-earned gains.
- You’ll be earning money more consistently.
The first one matters because, done well, these approaches should save you at least 10% at the end of your bubble trade. Since bubble trades aim at 10x, that’s the equivalent of 100% of your initial investment. This idea literally doubles your money.
The second matters because this is really a psychological game. Yes, there is strategy and logic. But the reasons you fail will mostly turn on psychological points. If you have at least one part of your portfolio that’s winning, then it’s a lot easier to continue putting in the effort to make consistent returns.
Paid subscribers already know the output of my basic economic cycle indicator, which has a 22-year history and better than a 70% win ratio. They know how I use it to sell when I do and when I hodl–which is why I have more than a 12x gain on my first Ether buys this bull-run. And they even know when I decide to just stash money in my “lower returning” leveraged market trades (which do 40% – 60% annually) while waiting for a good bubble.
Yet even they will benefit from this information since I’ve never explained my rationale for what I’m doing.
This topic covers two lessons focused on anticipating what you fail to anticipate. In this lesson 14, I’m going to discuss the strategy of intelligent diversification. In the next, I’ll address the art of hedging well.
Let’s start with the basics.
Take a look at the following chart. Which investment would you want to be in, the black line or the blue line?
No brainer, right?
Well, let’s back that chart up a few months, how about now, which one performed better?
You might say that they ended up at the same point, but would you rather be in the investment with wild swings or the one with a gentle upwards slope?
These are the SPY, or the index of the S&P 500 and the IEF, or the index of 7-10 year US Treasuries.
Generally, they are uncorrelated, but in times of crisis, they tend to be inversely correlated. If you run a correlation matrix on these two funds since 1994, this is what you get.
That’s a negative .3 correlation. Meaning that when one goes up the other, much of the time, goes down. This is a statistically significant measure, but it’s only moderately strong.
The reason they tend to be inversely correlated during times of crisis is that bonds are thought to be safe-haven assets. As a result, in a crisis, more people buy them and their value increases.
To get a better sense of truly un-correlated assets, rather than inversely correlated assets, look at the following correlation matrix of the S&P and gold (in the $GLD fund).
They look to be very slightly inversely correlated, but anything below a .1 correlation is actually meaningless. These funds just do their own thing. Gold isn’t really a safe-haven asset. It doesn’t really go up when the SPY goes down. They’re just different.
Now you might think that inversely correlated assets are better, but they’re not always. They have the same reasons for moving as they do, even if they move in opposite ways. That means that if you have a lot of inversely correlated assets, you’ll not really be addressing what you fail to anticipate.
Ray Dalio, the director of the world’s largest hedge fund, used the value of uncorrelated assets to build his massive wealth and called it the “holy grail” of investing. Let’s look at it.
The Holy Grail
In his book Principles, Dalio writes about the topic this way.
From my earlier failures, I knew that no matter how confident I was in making any one bet I could still be wrong—and that proper diversification was the key to reducing risks without reducing returns. If I could build a portfolio filled with high-quality return streams that were properly diversified (they zigged and zagged in ways that balanced each other out), I could offer clients an overall portfolio return much more consistent and reliable than what they could get elsewhere.
It’s for this reason that Dalio invests globally, not just in the US, and he does so in stocks, bonds, commodities, derivatives, and other items.
But you’ll miss the idea entirely if you think that the point is to just to buy a lot of different stuff.
The real point here–this is the holy grail idea–is that how much risk you reduce in your portfolio has a limit. What that limit is depends on how uncorrelated a new asset is. The more uncorrelated an asset, the more it will reduce your risk.
Here’s the image Dalio uses; it’s from Bridgewater. The different lines represent different strategies. The red line, for example, has a 60% correlation among its items. The green line at the bottom has literally 0% correlation. The remaining lines represent intermediate levels of correlation.
The main point about these lines is that they are curved. You’ll notice that the red line starts to kink at about 3 different assets and is flat at 6. That “kink” in the curve is called an inflection point and the verb is “to inflect.”
The last line inflects around 10 uncorrelated assets, but never really goes flat. That means that you can indefinitely add more uncorrelated assets and reduce your risk.
It’s because of his focus on uncorrelated assets that Dalio, who is a kind of value investor, has slowly changed his story about Bitcoin. He became interested officially in January of this year.
Our question is, can we use this strategy but for bubbles?
The Holy Grail In Bubbles
Yes, absolutely and I have been doing this all along. Here is an image of four bubbles that I’ve been tracking: Bitcoin in black, the oil rebound in red, the green energy boom in green, and the cannabis boom in blue.
Notably, I used $RIG for the oil rebound, but I don’t currently hold it for reasons I’ve explained to my subscribers. I do hold other oil stocks. I also proxied cannabis with $CGC, even though $TLRY has done better in that graph (and I sold out for a 782% gain). The reason is that $CGC is a better indicator of the industry.
Those lines don’t look to follow each other closely, and if you run a correlation matrix, substituting a stock ($GBTC) for Bitcoin, this is what you get.
Nothing there is above a .18 correlation. That puts this portfolio somewhere between the grey and peach-colored lines in Dalio’s graph. The inflection point is around 8 assets.
This means that I could add more if I found more bubbles, but I see only 4 good bubbles at the moment. That’s why I stash the rest of my bubble trading money in a fifth logically unrelated asset strategy: a leveraged fund strategy.
Notably, everything in the cryptocurrency market is strongly correlated with Bitcoin’s movements, so about .9. That means that you can’t build portfolio diversification within the cryptocurrency world. You have to pick things outside it.
So, now you know what Black Swans are–unimagined events that can ruin your trading strategy–and one method to deal with them: intelligent portfolio diversification.
This isn’t dumb diversification, where you just buy a lot of different things. Rather, this is diversification where you buy unrelated asset classes. Tilray and Canopy Growth Company are both cannabis stocks. They will tend to fail or succeed for the same reasons. Even though they are competing ideas, $TSLA and $PLUG are both parts of the green energy boom.
You need to look at different bubbles and follow all of them. When you are starting out, I realize that you only have so much money. As you grow it, though, you’ll want to make sure that your new funds don’t go back into the same area.
This will make the likelihood of your portfolio losing a lot for unforeseeable reasons much lower. It’ll also make your gains much more consistent. When oil crashes, cannabis might be going up. This way, you can look at the bright spots in your holdings and continue on.
As always, bubbles only do well as long as the basic economic cycle is doing well. That’s why the foundation of my approach is to make sure that is ok before I start looking at these industries. Daily subscribers get a daily read-out of that algorithm, weekly subscribers get a weekly readout.
They also get my analysis of each sector and whatever news is relevant for that period of time.
However you monitor that, just be sure that you do.
Next week I’ll follow this post up with the art of the hedge, which I use to save about 10% of my gains at the end of a bubble … which is double my initial investment.
Notes & Disclosures
General financial disclaimer: I am not providing advice on financial investments and I am not a financial advisor. I am only explaining how I think about this process and imply no returns on your investments. As they say in the news industry, this is for entertainment purposes only. Please do your own due diligence before investing in anything.
Specific disclaimer: At the time of writing, I own a variety of cryptocurrencies, including Bitcoin and Ethereum. In general, I trade these, so by the time you read this, I may not still own them.