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Jan 17

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Diversification Challenges in Today’s Market

Diversification refers to the process on reducing one’s overall risk by investing in different assets that have different characteristics.  If the various asset values do not move up and down together, then a diversified group of investments will have less variability or risk than the weighted average of its constituent parts.   Diversification works because the investment in each individual asset is reduced. 

Diversification is successful as an investment tactic only if there is a lack of correlation between the various assets that are owned.   This has become more difficult in recent years as various asset classes whose values used to move up or down differently now behave in much the same way.  Every recent reliable mathematical study on this subject shows that asset classes that used to work well for diversification now are less useful for that purpose.   

Mathematically, diversification is calculated with correlation coefficients.  A correlation coefficient of positive 1.0 means that the assets in the formula rise and fall together.  A negative correlation (again to a maximum amount of negative 1.0) means the assets more exactly the opposite.  Generally, investments with a correlation coefficient of .2 or less are viewed as providing excellent diversification, while investments with a correlation coefficient of .8 or greater is viewed as not providing meaningful diversification.   The challenge faced by current investors is that correlation coefficients for the majority of asset classes (e.g., small capitalization stocks, large capitalization stocks, international stocks, and stocks of most industry groups) are currently in the .8 and higher range. 

Why is this occurring?  As the various financial markets, trading platforms, and market components become easier to access, it is simpler to build a diversified portfolio.  Investors are placing more money into these previously difficult-to-access assets.  In addition to the changes in markets themselves, exchange traded funds, or ETFs have exploded in terms of the amounts of assets invested.  ETFs make investment in specific market segments both easy to understand and accomplish. 

Bonds and stocks still do have significant diversification characteristics.  Those who diversified with bonds during the last few years fared much better than those who did not.  However, with interest rates as low as currently exists, bonds have very little yield and face significant price downside risk when (not if) interest rates rise.  For this reason, this author encourages (in the today’s environment) a current under-weighting for bonds. 

In the short-term, a possible strategy in this environment is to invest in high-dividend paying stocks.  It is easy to find large, mature (and generally viewed as “safe”) stocks with dividend yields higher than what bonds are paying.  The dividend yield on  such stocks should provide (i) downside diversification protection vs. other stocks, and (ii)  behave differently than bonds when interest rates rise, because stocks have upside earnings and inflation opportunities different than bonds. 

Here is practical advice on how to address these issues:

  1. Article on ETFs, with specific securities to consider
  2. Online calculator for determining asset allocations based on our interactive risk tolerance questionnaire and age
  3. An article on how much retirement savings you need

About the author

David Nolte

I am a founding principal of Fulcrum Inquiry, an accounting and economic consulting firm that performs damage analysis for commercial litigation, forensic accountings, financial investigations, and business valuations. I am a Certified Public Accountant (CPA) and an Accredited Senior Appraiser (ASA), as well as having other professional credentials. I regularly serve as an expert witness involving damages measurement. My litigation-oriented resume is on Fulcrum's website.

Permanent link to this article: http://betweenthenumbers.net/2011/01/diversification-challenges-in-todays-market/

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