Diversification Is NOT A Strategy Of The Past

In light of recent market events, it’s understandable that people would be a bit jittery about the market.  Now more than ever, Americans need sound personal finance advice to keep them from doing something stupid.  That’s why I am extremely disturbed to see articles on respected financial websites declaring the death of diversification as an investment strategy.

Diversification Is Not Dead

Let me be clear, diversification is not a strategy of the past.  It seems Mr. Simon Maierhofer lacks a clear understanding of what exactly diversification is and what it can and cannot accomplish.  Diversification is not a magic bullet.  It cannot prevent steep losses in times of financial crisis like we’ve recently experienced; nobody has ever claimed it can.  What diversification does do, however, is dramatically decrease the odds of experiencing massive losses like even diversified portfolios have done of late.

Diversification is built on the principle of combining non-correlated risky asset classes in a bid to decrease investment risk while holding returns steady (or perhaps even increasing them a bit, if you’re lucky).  In essence, a portfolio of many different asset classes will usually contain some investments that zig while others zag, smoothing returns and decreasing the risk of catastrophic loss.  David Swensen’s book Unconventional Success contains one of the best explanations I’ve ever seen on how exactly diversification works.

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Unfortunately, diversification doesn’t always work.  In the real world, it’s nearly impossible to find two asset classes completely non-correlated with each other, much less three or more.  At best, one can hope to build a portfolio of asset classes only mildly correlated with each other.  Bonds often zig when stocks zag, but only some of the time.  Occasionally, the stars will align and all asset classes will move more or less in sync with each other, as they did in the most recent crash.  The odds of this happening are quite low, but even low-probability events happen occasionally.  Additionally, there is actually some evidence that correlation co-efficients are on the rise.  These things tend to move in cycles, however;  the only thing we can be certain of is that co-efficients of correlation will change over time.

Obviously, a rare coupling of global asset classes doesn’t mean diversification doesn’t work any more.  To the contrary, you can be 100% certain that with a diversified portfolio, you will occasionally suffer steep losses:  the laws of probability demand it.  So why do we diversify?  Quite simply, we diversify because while it’s not a perfect system, it’s by far the best and most consistent one.  Over time, a diversified portfolio is far more likely to deliver good returns with an acceptable amount of risk than any other investment strategy.  Is it guaranteed?  No, but it still rates higher than any other strategy I’ve seen proposed.  Good investment advice doesn’t change merely because the market is down.

Stay Diversified At All Costs!

Your best bet is to develop an asset allocation plan suitable for your age, investment goals, and risk tolerance with the help of a reputable, responsible financial website such as Morningstar (notice I didn’t mention Yahoo Finance).  Now more than ever, it’s essential that you ignore the noise and remain diversified despite a lot of misguided advice to the contrary, a technique coined by a fellow blogger Mike Piper called Oblivious Investing (read my review of his Oblivious Investing book).