The concept of portfolio diversification as a means to minimize risk for individual investors gained attention in the 1950s and 1960s. According to Wikipedia, “Diversification in finance means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets …”

Diversification is actually a common risk management technique that applies to more than investing. About the time of the Revolutionary War, someone figured out that if forces were diversified across the terrain instead of bunched together in a group, survival rates increased—especially when confronting a superior foe.

When the concept caught hold on Wall Street, diversification was appealing for another reason. At the time, trading stocks presented ordinary investors with several challenges. There was no Internet or discount brokerages. Trades were generally executed through full service brokerage firms. Brokerage fees and commissions were hefty and frequent trading could quickly erase an investor’s gains. So traders and investors were eager to embrace a practice that lessened trading expenses while also lowering portfolio risk.

Again quoting Wikipedia, “by the end of the 1960s, there were approximately 270 [mutual] funds.” Compare that to the thousands of mutual funds that exist today. Exchange-traded funds (ETFs) did not exist. In short, investors of that era had far fewer investment options that we do now.

The investing world has seen dramatic changes since the concept of diversification was first proposed. While the idea is still valid, many investors and professional money managers fail to understand the difficulty of achieving real portfolio diversification.

There is a misconception that investors can significantly reduce their portfolio risk by dividing their assets among different asset categories, such as large cap stocks, small cap stocks, international stocks, value stocks, market sectors and bonds. The misconception is that because these assets are varied, they will not move in concert. Unfortunately, while their movements might not be completely in sync, that does not mean they are uncorrelated enough to offer significant diversification.

This point is easy to see with a simple price chart. On the chart below I have included five ETFs and one index representing six different asset categories. As the chart clearly shows, over the past two years five of the six asset classes have shown a high level of correlation. The only investment that showed significant variation was U.S. government bonds (TLT). And bonds benefited from a flight to quality in 2008 as the equity markets plunged.

What this means is that an investor who purchased these six different investment alternatives in equal portions would actually have had very little diversification or protection from market risk over the two-year period represented by this chart.

Changes in the financial industry might contribute to today’s synchronization of the equity markets. Investors and traders have more access to information today than ever before. Just 15 years ago it was difficult for ordinary investors to know what a given stock was doing during the day. Today anyone with a connection to the Internet can follow the markets minute by minute. Online trades occur almost instantly.

Even international positions do not provide the diversification they once did. Shares of many companies are traded on exchanges of several countries. Globalization means that a Dutch-owned company that does lots of business in the Far East might trade heavily on any given day on U.S. stock exchanges.

After the market decline of 2000-2002, some investors sought risk protection and diversification by purchasing real estate. That decision also turned out poorly for many when real estate faltered in 2008.

In spite of the high correlation among stock market asset classes, many advisors still tell clients that diversification models designed in the 1950s and 1960s offer protection against market risk. One such company in our area has a flashing billboard that encourages people to ask about its Nobel Prize winning investment strategy. I suspect they neglect to tell people that the strategy was devised in the 1950s. It’s similar to a phone store putting up a sign that says “ask us about our rotary dial, corded telephones.”

What many advisors overlook is that there are a wide range of investment products available today that did not exist 50 years ago. These include products that offer real diversification and provide true protection against market risk. In general, they cannot be mentioned here unless I am willing to add some lengthy legal disclosures.

But be aware that if your advisor tells you that asset class diversification is the answer to protecting your investment portfolio against market risk, you might want to talk to someone else.
 F.S.

A market that is moving sideways is difficult for many investors and traders to endure. Even more challenging is a sideways market with high volatility. And that is precisely the current situation.

After a sharp downward move that began in April, for the past month major indices have been vacillating up and down. Stocks began an upward track after the first week of June, but the past couple of sessions have seen them falter.

Below is a chart of the S&P 500 Index. I’ve added two lines to help illustrate the current situation. The red line highlights an area of strong support—at about the 1050 level. Three times in the past six months this index has fallen to this area and each time has been unable to penetrate lower. Just a couple of weeks ago it appeared almost certain that this support would not hold. Stocks were falling and economic reports were gloomy. But stocks rallied back.

The red line is about the level where I anticipate the S&P 500 will find resistance. Unless the S&P 500 can break strongly above this level, there seems to be little point in taking new long positions.

The middle portion of the chart is a relative strength index (RSI). The RSI needs to trend above 50 if the index is going to have enough momentum to sustain an advance. It is currently hovering right at that level.

The bottom portion is a moving average convergence divergence (MACD). It began moving upward in early June, but had not yet climbed into positive territory. Until it breaks that barrier and holds above zero, any positive moves by the index must be viewed with suspicion.

Summer is traditionally a weak season for the stock market. Of course 2009 proved to be an exception. I don’t profess to know what direction stocks are headed when they break out of this sideways move. But given current weak economic fundamentals, it would not surprise me to see stocks move generally sideways for the next several months.

One other seasonal factor that can increase the volatility of market moves is declines in trading volume. Summer means vacations, so trading volume often falls with people away from the markets. As a result market movements can become exaggerated if economic news causes investors to feel a need to move in or out.

For now the best course of action for investors is to maintain a close watch on market movements and wait for indicators to signal that a new trend is developing.
F.S.

Nothing new to report today. The S&P 500 is almost where it was a week ago and almost exactly where it was on May 21. The only thing investors can do right now is wait and watch to see which way it breaks.

FS

After the impressive market rally of 2009, many investors were again becoming complacent. They started to believe that the days of easy money had returned and that all one had to do was buy stocks and collect the profits.

Often a short-term view provides a distorted picture of the present situation. From time to time it is wise to step back and take a long-term look to see where we are and where we have been.

The chart below shows performance of the S&P 500 over the past 15 years. I added the red line to mark the current level of the index. As it clearly shows, the first time the index crossed this level was in early 1998. So an investor who purchased this index in 1998 and held it until now would have realized zero return in his investment.

To help put that time frame in perspective, in 1998 Bill Clinton was president of the United States and embroiled in the Monica Lewinsky scandal. The twin towers of the World Trade Center were still a landmark and a dominant feature of the New York City skyline. Gas was $1.15 a gallon and a first class postage stamp was 32 cents. It was the year Google was formed and the X-Files was one of the more popular television programs.

Two times the markets advanced strongly above this level, but each advance was followed by an equally powerful fall. Given the current economic state, any advance from this point must be viewed with caution.

This chart is evidence against the argument that the best way for investors to make money in the markets is to buy index funds and simply hold them until the money is needed. Investors who bought into that philosophy in 1998 are finding themselves exactly where they started.

Investments need to be monitored and managed to avoid periods of excessive risk and to take advantage of periods that offer a reasonable opportunity for gains.

F.S.