Dorato News - July 2025

Portfolio Issues - Diversification

We all have a common sense view of what diversification is: Don’t put all your eggs in one basket. But in the investment world, there’s a more precise meaning, and being aware of it can keep you from having too many baskets.

There are two keys to an asset that provides good diversification. One is that the asset has a positive expected return, and two is that the asset’s returns are not highly correlated with other assets in your portfolio.

So bonds offer good diversification for stocks. They have a positive expected return and a relatively low correlation with stock returns. That makes sense. Bond returns are primarily driven by interest rates. Stock returns are primarily driven by earnings.

Finance folks talk about diversification being a free lunch, because you can reduce the volatility of your portfolio without giving up very much in return.

When we hear people talk about gold or bitcoin for diversification, our problem is that we have no idea what the expected return is for gold or bitcoin. Prices may not be highly correlated with stocks, but what is a reasonable price for gold or bitcoin? And what is a reasonable expectation for their prices a year from now? We have no idea.

The S&P 500 is highly concentrated in a handful of relatively expensive companies, so some diversification away from the S&P 500 — to international stocks, and dividend-paying stocks — should improve our expected returns; but we want to be thoughtful about which baskets we use and how many we really need.

“I don’t know about diversification, but I’m kind of excited about a free lunch.”

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Market View - Guessing Games

The S&P 500 is back near all-time highs. The index dropped 20% in April, but then recovered as fears of tariff-induced inflation subsided. Investors seem to think that trade deals will be negotiated and impacts from tariffs will be either temporary or minimal. The rapid drop and subsequent recovery are a good reminder that reacting to short-term movements in the markets will ultimately hurt long-term returns. Trying to get in and out of the market based on recent news is best left to traders, not investors.   

Big technology companies led returns in the second quarter, a complete flip from the first quarter. Stocks such as Nvidia rose close to 60% from recent lows. Money continues to pour into all manner of companies linked to artificial intelligence (AI), whether they are earning money or not. Companies such as Salesforce believe they can accomplish the majority of their work through AI. Eliminating labor costs while still growing revenues sure sounds like an ideal situation for business leaders, but we are still in the early stages of this technology. Its uses will continue to evolve in ways that aren’t obvious at the moment. We continue to think that AI is in the midst of a bubble. Valuations are extremely high, leaving little room for unforeseen bumps.  

Geopolitical tensions dominate the headlines. The war in Ukraine grinds on; and while Iran and Israel currently operate under a cease-fire, the conflict is not over. How the situation with Iran progresses is unclear, but it is unlikely we will see any oil shocks severe enough to damage the world economy, and even less so for the US economy because the US is not nearly as dependent on foreign oil as in the past.

We continue to recommend a diversified portfolio of stocks. In particular, we continue to emphasize dividend-paying stocks, such as in the healthcare, industrial, and defense sectors. Companies that demonstrate the financial discipline to pay dividends through various economic environments should remain attractive investments now and into the future.

Stablecoin legislation recently passed into law. Stablecoins are a form of cryptocurrency that are linked to the US dollar. Large companies and banks are rumored to be working on their own stablecoins to avoid paying fees on credit cards. To be clear: Stablecoins are not Bitcoin. The legislation requires that any stablecoin is backed 100% by safe assets, such as US Treasury bills. That is not the case with Bitcoin. The risk we see is that while the Federal Deposit and Insurance Corporation (FDIC) will regulate stablecoins, stablecoins will not be backed by the federal government, as bank accounts are. This will create confusion for consumers. We mention stablecoins because they are an example of how legislative changes can affect all of us. Our guess is that the federal government will end up backing stablecoins, especially if enough people start to use them.

The national debt is a serious problem. So far, it hasn’t led to an economic crisis, and we are not predicting one in the near future. But the US cannot keep running deficits at these levels indefinitely. The current debt is higher than it was at the end of World War II, as a percentage of the economy; and our annual deficits are as big as they were during recent crises, yet there is no crisis that we’re aware of. How long this can continue is anyone’s guess. The place to watch is the bond markets. If long-term rates rise, that will show that investors are losing confidence in the US’s future.

We recommend staying steady through the ups and downs. Making large changes in long-term strategy in response to new technology or government policy is more akin to gambling than investing. Predictions for both of these areas are often wrong and the outcomes are only obvious in hindsight.

Sources: Economist, Wall Street Journal, Value Line, Vanguard, Applied Finance Group, Schwab