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.