This blog covers the general topic of financial markets.

GIRY 2022: focus on inflation and diversification

first posted: 2022-07-31 16:48:58.934674

Ever since his 2000 book "the triumph of the optimist", british scholar Elroy Dimson continues to update century plus investment outcome data. The book is structured as follow:

  • Purpose and Coverage
  • Long run returns on stocks bills and inflation
  • FX, long run rates change and inflation, PPP and the case for hedging
  • Risks: extreme equity and bond drawdown
  • Factor investing: value, momentum, volatility
  • Prospective factor premiums
  • Diversification

The topics discussed in 2022 are inflation and diversification.


Bonds perform badly during inflationary periods. Equities also perform badly in the worst inflation. In such case, precious metals and real estate were the best hedges.

The best equity and bond real returns occur when inflation is low. Equity are less sensitive to inflation.

The authors back test a strategy to go long equity or bonds when rate started to hike/fall and closing the position when the opposite policy is taken by the Fed. The strategy of going long equity and bond when rates are being cut captures most of the bond positive return and much of the equity premium.

The volatility is definitely higher when rates fall, but that's when money was made.


Number of Stocks

Diversification is the only free lunch in investments. The authors cite various studies showing that many retail investors have only 4 stocks. Even 100 stocks leaves 3% of residual tracking error compared to a full market index.


Country diversification (if US is always included first) appears to reduce volatility by 15% when all countries are included. For other country investors, home country bias is indeed adding risk, as adding other countries has the potential to reduce risk by 50%.

The impact of diversifying the portfolio is a small loss for a US portfolio because US had higher returns than other countries. However, we see that most countries benefit. The impact is up to +0.3 of Sharpe (Greece, Italy) to a small -0.1 for US, Chile, Mexico.

In general, fx hedging foreign assets does not impact total return a lot in JP and US, though it leads to 0.05 improvement of the Sharpe in Britain and core Europe area countries.

It should be noted that globalization followed a U trajectory. With much foreign investment by Europeans in 1900, followed by war confiscation, and capital controls in UK, Germany and France as late as the 80s. The Japanese market was effectively closed to foreigners until the 80s as well.

Since this opening, correlation increased massively, from 0 to 80% in UK-US, and -30% during wars to +80% for Germany-US. Therefore, much of the benefit may fail to materialize.

Similarly, EMK are much easier to access now, but their correlation has risen. So that a risk-off event applies to DM and EMK stocks.

Stock bonds diversification

The authors make the point that bonds have recently made much better diversifiers. The negative correlation experienced since he Fed put in 2000 leads to an optimal sharpe ratio for a 60/40 portfolio. If a positive correlation assumption is used however, the optimal sharpe corresponds to the equity only portfolio.