Martin Pelletier: There is no such thing as a free lunch, but as investor Barry Ritholz observed, the closest thing to it is diversification
Tech markets took a nosedive last Monday with Nvidia Corp., one of the world’s largest companies, losing more than 17 per cent of its value in one day, totalling approximately $600 billion dollars.
This came on the back of an emerging competitive artificial intelligence (AI) from China named DeepSeek that seems to be able to deliver results with a fraction of the cost and requiring less processing power than existing models like OpenAI. This isn’t good news for GPU advanced chip manufacturers like Nvidia. Even more interesting is that it is an open-source model, which would allow for users to rapidly improve its performance.
Although tech stocks have somewhat recovered since the DeepSeek shock, last week’s action should have been an excellent stress test for your portfolio in regard to its downside risk exposure. Instead, all I heard was pundits getting defensive, recommending to buy the dip and coming up with all kinds of excuses as to why DeepSeek wasn’t as much a disruptive threat as it could be.
I felt alone in wondering why a company the size of Nvidia that makes up a massive seven per cent of the S&P 500 could lose so much of its value in just one day. I also wondered why the same people who rapidly embraced OpenAI Inc. two years ago were doing the opposite with DeepSeek?
This brings me to a saying I live by when managing portfolios. You can live by the sword and die by the sword, or you can diversify. However, we currently live in a world where many are telling you diversification is bad.
Why own bonds when they’ve performed so poorly? Why own international markets when they’ve paled in comparison to U.S. markets? Heck, even the mighty S&P 500 has thrown in the towel as the Magnificent Seven tech stocks now represent over one-third of the index, up from a fifth of the index two years ago.
Can it really be that easy?
In the context of the market action over the past 10 years, apparently it is. The near 20 per cent drop in the S&P 500 in 2020 seems like a distant memory, given two back-to-back years of more than 20 per cent gains. Prior to 2020 there were similar high returns with few lasting corrections.
Investors who diversified may have achieved decent returns with less variability, but I fear that they may capitulate to the mantra that U.S. tech stocks only go up and wonder why they should own anything else?
The problem is that markets have cycles, and you better get the timing right if going all-in. For example, the decade following the dotcom bubble bursting, U.S. tech stocks got pummelled. They contributed less and less to the S&P 500, resulting in some material underperformance of the index. Meanwhile, the Chinese infrastructure boom and the corresponding bull run in commodities resulted in outstanding performance in resource-based stock markets such as in Canada or emerging markets. It, too, at that time was the only place to be and many investors wondered why they would own anything else.
The best solution for high prices is high prices. Rocketing oil prices rapidly incentivized U.S. shale development, which flooded the market with oil, resulting in an OPEC price war and the resulting end of the bull run in oil. At the same time, the China story unravelled as the country took on too much debt and overbuilt.
This is called disruption.
A swift mean reversion leaves many who got the timing wrong with a lot of damage and their portfolio can take a long time to recover. This is why you diversify as you get older, as having a large position in one position losing 17 per cent in one day can become unbearable, despite the promise of continued high double-digit returns.
Remember this whenever hearing strategists talk only about highly volatile investments, such as cryptocurrencies and tech stocks. Sure, these could play some part in a portfolio and certainly make for a great narrative, but the focus really should be on ways to generate targeted returns to meet financial goals and objectives while mitigating the risk.
The best way to do this is via good old-fashioned portfolio construction and diversification via the addition of low correlated asset classes. Ray Dalio, founder of Bridgewater Associates and author of Principles, said it best: “Everybody pays attention to returns, and they don’t pay attention to risks as much. And that’s one of the reasons we’ve been successful because think of it this way. If you lose 50 per cent, you’ve got to make 100 per cent to get back.” There is no such thing as a free lunch, but as investor Barry Ritholz observed, the closest thing to it is diversification.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.
