The Diversification Trap

Almost two years ago, I wrote about why diversification isn’t a free lunch. Now, I’m watching everyone pile into gold, and I need to say something. Me that four years ago, inspired by PortfolioCharts, wrote this about gold.

But that was back then, when nobody cared.

Today? Everyone’s buying it. And I think I know why: after gold’s massive run, it feels like free diversification. The psychological appeal is obvious:

• You’re not sacrificing returns (gold’s been crushing it)
• It’s a diversifier (protection if overvalued stocks crash)
• Everyone else is doing it (social proof is powerful)

Here’s the thing: gold is a diversifier over the long term. But in the short term, especially considering what it did recently, it’ll probably behave exactly like stocks.

It’s a diversifier simply because it does its own thing.

Think about how many times you’ve heard someone complain: “I was promised bonds were inversely correlated to stocks!” Well, not really. Assets can spend years negatively correlated, then flip and spend just as long positively correlated. There are some structural reasons behind each relationship but you have to look at it like valuations: it takes time to really matter (and you have to look at the right reasons).

I don’t think a gold crash would drag stocks down. But the reverse? That’s likely. If stocks crater, gold will follow.

The Leverage Problem

As Cem Karsan often says, the market itself is the main contributor to market liquidity. Getting leverage is easy: your assets go up, you borrow more, you buy more assets. I’m not trying to sound like a doomsday YouTube channel here, this is just how markets work. Most people are even doing it responsibly. But it’s still fueling markets in a massive way.

When that engine reverses, liquidity evaporates fast.

And here’s what happens: stocks fall and investors get margin calls. They need to liquidate something. And gold? It’s the perfect candidate: highly liquid and up significantly.

The Liquidity Cascade

That’s how Corey Hoffstein calls it. Investors facing sudden losses or margin calls rush to sell assets to raise cash. They don’t just sell their worst performers, they often sell their safest holdings because they are liquid and they need to rebalance. While gold is typically seen as a safe haven, in a severe crash, investors may be forced to sell it to cover losses elsewhere.

The mechanics are simple:

• Investors need cash urgently, so they sell whatever’s liquid
• This creates a ripple effect: more selling begets lower prices
• Even “safe” assets get swept up in the selling pressure

Gold’s price can drop even if its long-term fundamentals (whatever they are) remain valid.

The Inevitable Complaints

I’m already bracing for the flood of complaints when this happens: “I was promised gold was uncorrelated to stocks!!1!”

But that’s exactly why diversification works: not because assets never move together, but because these relationships shift over time. Diversification worked in the past and will work again in the future precisely because nothing is a guaranteed safe haven in every market environment. Especially if you are fixated with the short term. The more something has worked in the recent past, the more investors will pile in…and the more likely it is that the same strategy will stop working in the future. Rinse and repeat.

Diversify your diversifiers.

First and second responders.

The investors who understand this, who know that correlations are dynamic and that short-term behaviour can deviate wildly from long-term patterns, are the ones who’ll stick with their strategy when everyone else is panicking.

So before you add gold to your portfolio because it had a great run and “everyone else is doing it” remember: there’s no such thing as a free lunch. Not with diversification, not with gold, not with anything.

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