Why 2 Asset Classes?

Nobel winner, Harry Markowitz explicitly said “It is necessary to avoid investing in securities with high covariances among themselves.” He also said to invest in an asset class one has to have “beliefs about the future performances of available securities.” Therefore the question becomes, how many asset classes are truly needed to develop a fully diversified strategy. In their 2018 paper, When Diversification Fails, authors and T. Rowe Price portfolio managers, Sébastien Page, CFA, and Robert A. Panariello, CFA conclude: “diversification seems to disappear when investors need it the most. We surmise that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—in particular, on exposure to loss.” They recommend: “When market sentiment suddenly turns negative and fear grips markets, government bonds almost always rally because of the flight-to-safety effect (Gulko 2002). In a sense, duration risk may be the only true source of diversification in multi-asset portfolios. Therefore, the expected stock-bond correlation is one of the most important inputs to the asset allocation decision.” So the answer is stocks and bonds are the only 2 asset classes needed to create a truly diversified portfolio.