If you love stocks

Some longtime investors who think a lot about risk, like Peter
Bernstein, the author of Against the Gods: The Remarkable
Story of Risk (John Wiley & Sons, 1996), want to have an
added hedge in their portfolio just in case the worst happens. A
hedge is a bet against your main strategy—which is why you
pray you are wrong to make this bet. You should hedge
against a low-probability occurrence that could have very big
consequences.
Here is an example: If you love stocks, load up, but put a
small portion of your portfolio into long-dated zero coupon
bonds—5 percent to 10 percent, say, depending on the seriousness
of the consequences if the worst happens. You pay well
under the face value for these bonds because there are no cash
interest payments to you. You get the implied interest payments
back when the bond matures and you are paid its face value. If
something bad happens that drives interest rates and stocks
sharply lower, like a recession, 30-year zero coupon bonds do
very well. If interest rates fall by two full percentage points, the
value of the zero coupon bonds would go up 60 percent.

DIVERSIFYING BY ASSET CLASS

While diversification abroad, as a way to reduce risk in a stock
portfolio, has become less rewarding because of rising correlations,
diversification by asset class is still holding its own. Correlations
between stocks and commodities and stocks and bonds
are still very low, although there will always be periods when they
all follow each other.
This is not only a good idea because of the theory of diversification;
it is also a good idea in a world where financial advice—
including this book—is ever more available to the everyday
investor. There are many more voices out there advising investors
to do this or that. A lot of this advice is to jump onto this bandwagon
or to jump off of that bandwagon. And because it is so
much easier for retail investors to put this advice into action, diversification
is a good hedge against the problem with following a
lot of different financial advice: Some of it is wrong.

MSCI to the U.S. market

Take South Korea, for example, whose stock market capitalization
accounted for 15.5 percent of the MSCI emerging market
index. South Korea’s correlation with the American market has
surged, doubling in the three years from April of 2000 to April of
2003 to 0.607. By December of 2006, the correlation level was
up to 0.649.
At the same time, the correlation level was also rising sharply
in the fifth largest emerging stock market, Brazil, which was 10.5
percent of the emerging market index at the end of 2006. Its correlation
had jumped to 0.705 by May of 2005, more than doubling
from the level in July

Correlation of emerging markets

As in developed markets, the correlation of emerging markets
to the United States went over 0.6 in August 1998 and has stayed
above 0.6 since. Before then, the closest a correlation had gotten
to 0.6 was 0.548 in July 1995, according to the analysis of stock
market return data from MSCI that begins its monthly readings
of five-year rolling correlations in December 1992.

Emerging markets

That was the year after emerging markets plunged when
Thailand’s sudden devaluation of its currency, the baht, triggered
the worst sell-off ever in these markets. In the summer and fall of
1998 things got worse as Russia defaulted on some of its debt
and devalued its own currency, the ruble. And the American stock
and bond markets were roiled by the near-failure of the giant
hedge fund, Long-Term Capital Management.

Ten developed stock markets

Ten developed stock markets, including Germany, Italy,
France, and Switzerland, registered their highest correlation levels
with the American stock market in 2006. And four others, Australia,
Denmark, Norway, and Sweden, reached their highest correlation
levels ever in the last eight months of 2005.

Emerging markets plunged

That was the year after emerging markets plunged when
Thailand’s sudden devaluation of its currency, the baht, triggered
the worst sell-off ever in these markets. In the summer and fall of
1998 things got worse as Russia defaulted on some of its debt
and devalued its own currency, the ruble. And the American stock
and bond markets were roiled by the near-failure of the giant
hedge fund, Long-Term Capital Management.

Emerging markets in the United States

This rise in correlations may not be so surprising because the
stock markets in all these developed countries have become more
and more alike, as have their economic policies. But there also
has been a striking increase in the correlation of the movements
in emerging markets to those in the United States. And that big
shift up in correlations with emerging markets came at the same
time as in developed markets: in the summer of 1998.

Markets Department at the International Monetary Fund

Hung Tran, the deputy director of the Monetary and Capital
Markets Department at the International Monetary Fund, acknowledged
that this study was limited because it did not include
more countries, especially emerging markets. But he said it still
made a point about the rising correlations of markets around the
world.

Mel B gives her fellow Spice Girls sex advice.

Mel B gives her fellow Spice Girls sex advice.

Victoria Beckham has revealed she and the rest of the band -
Emma Bunton, Mel C and Geri Halliwell - constantly go to Scary Spice
Mel with their bedroom problems.

Victoria said: "If we have sex problems, we go to Mel B - she is like the doctor."

Mel
- who has a nine-month-old baby, Angel Iris, with ex-boyfriend Eddie
Murphy and an eight-year-old daughter, Phoenix Chi, with first husband
Jimmy Gulzar - has always been rumoured to have a wild sex life.

In 2004, she sparked bisexual rumours when she was pictured kissing a film executive known only as Christine.

Mel
- who is now married to movie producer Stephen Belafonte -also
allegedly enjoyed lesbian threesomes with her friend Christa Parker and
actress Elizabeth Rodriguez last year at her Los Angeles home.

Mother-of-two
Christa claimed: "I had only had sex with a woman once before, but Mel
was obviously very experienced with women. She is a great kisser.

The U.S. stock market dropped 8 percent

In May and June of 2006, there was a slump in global stock
markets, triggered by a sudden spike of inflation jitters in the
United States. The U.S. stock market dropped 8 percent, developed
markets outside the United States fell 14.9 percent, and
emerging markets plunged 24.5 percent, based on MSCI data.
A study by economists at the International Monetary Fund
highlights the diminishing benefits of diversifying abroad very
bluntly. The study shows that although American investors are
the least diversified of the investors in the four-country study
(United States, Germany, United Kingdom, and Japan), they have
only a “limited amount” to gain by diversifying more

The index for the United Kingdom had a gain of 8.6 percent

This lack of correlation had also been true when looking at the
performance of American stocks versus those abroad. In 1978, for
example, stocks on Wall Street eked out a barely positive 0.4 percent
gain for the year, based on MSCI’s index for the United States.
The index for the United Kingdom had a gain of 8.6 percent, in
dollar terms. But that was nothing compared to the 50.1 percent
gain for the Japanese index and the 63.1 percent gain for the stock
index in France. In 1977, the U.S. market was off 12.2 percent,
while Japan was up 13.2 percent, Germany was up 21 percent, and
the United Kingdom was up 50.2 percent, all in dollar terms.

Economic knowledge

The economy is governed by two kinds of laws: the laws of supply and demand
and the laws enacted by governments. In this chapter we have begun to see how
these laws interact. Price controls and taxes are common in various markets in the
economy, and their effects are frequently debated in the press and among policymakers.
Even a little bit of economic knowledge can go a long way toward understanding
and evaluating these policies.
In subsequent chapters we will analyze many government policies in greater
detail. We will examine the effects of taxation more fully, and we will consider a
broader range of policies than we considered here. Yet the basic lessons of this
chapter will not change: When analyzing government policies, supply and demand
are the first and most useful tools of analysis.

Lehman Brothers U.S. Aggregate Index

Adding Treasury bills, notes, and bonds and other fixed-income
securities—a completely different asset class—gives you an even
better chance of having one part of the portfolio going up while
another part is falling or just creeping higher.
When the S&P 500’s total return fell 11.9 percent in 2001,
the return from the Lehman Brothers U.S. Aggregate Index, including
Treasury securities, investment-grade corporate bonds,
and mortgages, was 8.4 percent.

Largely on the firms and workers

Our analysis makes a clear prediction in this case. With elastic demand and
inelastic supply, the burden of a tax falls largely on the suppliers. That is, a tax
on yachts places a burden largely on the firms and workers who build yachts
because they end up getting a lower price for their product. The workers, however,
are not wealthy. Thus, the burden of a luxury tax falls more on the middle
class than on the rich.

The simple 50–50 split

You might retort that if all the portfolio were in the Russell 2000, it would
have fallen just 3 percent. But that is known only with hindsight.
With diversification, you have to commit yourself in advance to
the fact that a variety of securities in your portfolio will move in
different directions or at different paces. The simple 50–50 split of
this example is diversification, but you can do a lot more.

S&P 500 dropped

In 2001, when the total return for the S&P 500 dropped 11.9
percent, the total return for the Russell 2000 rose 2.5 percent; in
1998, when the total return for the S&P 500 was a gain of 28.6
percent, the return for the Russell 2000 dropped 2.6 percent.1 So
when one was up the other was down. That is diversification. To
reduce risk you have to accept the fact that something in your
portfolio may not always be doing well.

When market become unfavorable

The two panels of Figure 6-9 show a general lesson about how the burden of a
tax is divided: A tax burden falls more heavily on the side of the market that is less elastic.
Why is this true? In essence, the elasticity measures the willingness of buyers
or sellers to leave the market when conditions become unfavorable. A small elasticity
of demand means that buyers do not have good alternatives to consuming
this particular good. A small elasticity of supply means that sellers do not have
good alternatives to producing this particular good. When the good is taxed, the
side of the market with fewer good alternatives cannot easily leave the market and
must, therefore, bear more of the burden of the tax.
But we also have to say that in many cases you will just
have to grin and bear it. The need to add risk to increase potential
returns and the opportunities offered by investing
abroad overwhelm concerns about the diminished benefits from
diversification.

Problems with diversification into foreign country

This diminished benefit of diversification in stocks abroad is
another consequence of the globalization of the world’s
economies and the around-the-world fight against inflation. The
growth of companies with a global reach has also contributed to
this synchronization of markets, as has the speed of communication,
which allows more and more people to know what is going
on every second in markets around the world.