Diversification Cushions the Blow of Drawdowns, But at a Cost

One fear many investors have is incurring a large drop in the stock market. “Major drawdowns,” as defined by AQR Capital Management, are those where prices drop by at least 20% from peak to trough. The investment firm counts 11 such drops as having occurred in the stock market since 1926, or about one per decade.

Though stock prices have fully recovered within 27 months, on average, according to AQR’s data, realizing the recovery requires an investor to stay fully invested in stocks. This is something that’s much easier said than done. Various studies show a tendency to pull out of stocks when their prices are down. Even if someone sticks with their allocation to stocks, the drops can be painful. Major drawdowns can even be problematic from a timing standpoint, especially for those who had the unfortunate luck of reporting shortly before the drop occurred.

There is a simple solution for cushioning against the blow of such drops: diversify. Holding assets whose returns are affected by different risks than stocks lessens the impact drawdowns have on portfolio wealth. However, diversification can come at the cost of lower long-term returns, as an analysis from AQR shows.

Among the diversifiers looked at were 10-year U.S. government bonds (e.g., Treasuries). These are uncorrelated to stocks and have, on average, experienced positive returns during major drawdowns for stocks. A basket of commodities is comparatively more correlated to stocks than bonds but has historically had low correlations with stocks. Commodities do have higher long-term average returns than bonds, but with far longer tails. In other words, bonds offer better odds of cushioning the blow, while commodities offer greater average upside albeit with much larger upside and downside returns. (Expenses do not appear to have been factored into AQR’s data.)

Cash can also be used to diversify. Just moving 10% of the equity allocation into stocks has historically led to 2.8% better drawdown returns. While this may sound enticing, the trade-off is a 0.8% reduction in long-term returns. As is the case with bonds and commodities, the price of easing short-term pain is less long-term wealth.

What about other sources of protection? AQR looked at a few, the easiest to understand being gold and puts. Since 1986 (a short time period for this type of analysis), including an allocation to gold has led to positive returns during stock market drops of at least 10%, at the cost of lower average returns. Puts—options that allow the contract holder to sell at a preset price—have good defensive properties but lead to negative long-term returns. (Various factors affect the actual return of a put strategy, but AQR’s findings should serve as a warning sign in regard to continuously holding onto puts.)

As far as timing the market is concerned, it’s harder than it looks. AQR looked at the drawdowns relative to Yale professor Robert Shiller’s CAPE (cyclically adjusted price-earnings) ratio. They found no consistent patterns between the level of the long-term valuation indicator and when drawdowns occur. More so, stocks tended to continue to rise when the markets were “very expensive.” Such increases occurred “more than half of the time.” (To be fair, AQR is not completely opposed to making small tactical tilts based on valuation or momentum indicators but have suggested investors just “sin a little.”)

The only way to truly protect against stock market drops is to not be in the stock market. Hedges, such as puts, do pay off during drops, but the stock market rises far more than it falls; most calendar months have positive average monthly returns. Diversifying into uncorrelated assets, such as bonds, reduces the volatility of an all-stock portfolio, but at the cost of lower long-term returns.