Diversification is a core principle of investing intended to spread risk of loss by investing in numerous asset classes instead of one or two, like stocks and bonds. Investment managers look at a statistic called “correlations” to gauge the extent to which asset prices move together in the financial markets. The basic idea is to construct a portfolio where some holdings Zig while others Zag so that a loss in one is offset by a gain in another preserve account value.
Historically stocks and bonds have been inversely correlated, meaning when stocks declined bonds gained or at least did not lose value—due to their negative correlation. Looking back to the 2000-2002 and 2008-2009 market corrections this was the case, yet recently the correlations between stocks and bonds have become more similar. This was the case in the 2022 correction and most recently when President Trump first announced his Liberation Day tariffs last April. Economists attribute the mutation in how stock and bond prices move to concerns about future inflation—typically the Fed raises interest rates to fight inflation. This pushes bond yields higher causing bond prices to decline (a bond you own becomes worth less when a new issue yields more) so correlations become similar. Tariffs are considered inflationary, explaining the rise in bond yields and the positive correlation of stocks and bonds.
The fact is when constructing portfolios, diversification is only a part of what’s necessary to build-in adequate risk management. Investment managers must also consider earnings, valuations, inflation, liquidity, monetary policy and pending legislation, particularly tax & trade policy changes, when structuring portfolios. Market corrections happen during periods of market stress. Volatility is the empirical evidence of market stress, but typically there is always a trigger event, some Black Swan incident that amplifies selling often initiated by algorithmic trading. When this happens correlations among asset classes change often causing them to converge so every financial asset’s price moves together. This is precisely why diversification does not protect against market risk. It further explains why so many investors lose too much.
Market corrections result in a lot of wealth is lost, and the causes of corrections differ. Investment managers combat adverse changes through their investment process that on the one hand must be biased to stay invested because stocks historically outperform most other asset classes, but on the other hand their processes must adjust to economic shifts by reallocating to the best, probable, expected return opportunities given new market circumstances. The investment process must weigh the risk of staying invested holding the same holdings and asset weights with the reality that suffering a loss requires a greater gain to get back even—lose 50% and 100% is required to get back even. Prudent investing is about employing proactive risk management that works to strike the optimum balance among the objectives of Growth, Income, Safety, Liquidity and Tax Advantages at the appropriate time.
At ProActive Advisors our investment process was formulated on research into Bull & Bear market environments to identify which indicators had the greatest, historical predictive power of forecasting a market correction, optimizing how to weight them, combining them into a composite index to score the Health of the Market and converting that score into a probability using a sigmoid function. Back testing this process over 50 years of market history has provided us with a mathematical tool to monitor the risk/return tradeoff and make opportune changes to portfolio asset allocations.
Our investment process has served us well in the past due to our continual focus is on risk management and not simply diversifying using passive indexing. We are not making any statement or promises about future outcomes or principal protections here. We are only saying we have a well-defined process to monitor portfolios where we proactively ask “What Can Go Wrong” while striving to keep accounts within thresholds of suitable risk capacities we believe are warranted given client profiles and the Health of the Market.
Looking at the current market, we still favor gold, silver, copper and oil & gas while continuing to hold leading tech stocks and select market sectors. Recently we harvested significant profits in silver and have begun culling software holdings we expect to be adversely impacted by AI. Those proceeds are being invested in quality fixed income holdings where we can earn real returns above inflation. Given our expectation of 3.0% ongoing inflation, we know over 15 years the purchasing power of the dollar (and US debt) will erode by 56%, requiring a 4.8% minimum return after taxes (28% marginal income tax rate) to breakeven. Our short-term positioning in these fixed-income securities is to get paid while we wait for better opportunities the stock market will eventually provide.
In summary, we see geo-politics as unsettling to the financial markets and causing increased volatility but believe last year’s tax bill will create a torrent of animal spirits to propel GDP to 6.0% or greater in 2026. That growth plus greater productivity should lessen concerns about US debt levels and provide room for the Fed to modestly lower interest rates. And while there is justifiable acrimony about US leadership that is disrupting supply chains, international trade, and accelerating de-dollarization, we expect a weak dollar to also boost US exports, offsetting the move to dethrone King Dollar. Our conclusion is that all these factors support higher stock prices, reinforcing the importance of following our process until probabilities warrant change.