Have you heard the word “diversification” before? If you’ve ever met with an advisor or paid attention to the stock market, you’ve probably heard of the importance of diversification—i.e. spreading your money across a number of assets. You’ve probably heard that by doing so, you’ll reduce the risk level of your overall portfolio.

This is a half-truth. Diversification works well at the individual security level. Diversification does reduce the risk associated with any one particular stock, or what we call “company-specific risk.” It is wiser to hold 30 stocks as opposed to just one. This is obvious.

But diversification does little to reduce market risk—the risk of severe stock market decline. Modern Portfolio Theory claims that by combining different asset classes (i.e. US large cap, US small cap, international, etc.) you can lower the risk of the overall portfolio and potentially increase the return of the portfolio. This is because different asset classes behave differently at different times. In fact, we can measure how similarly asset classes perform and we call this “correlation.” Assets that are positively correlated do the same thing. Assets that are non-correlated show no relationship. And assets that are negatively correlated move oppositely. So the claim is that by combining non-correlated assets, we can reduce risk.

Well, here’s what happened in 2008 and 2009:

You’ll notice that all these asset classes did essentially the same thing with very little spread between the highest performers and the lowest performers. The problem with correlation is that it can change. Diversification does not do well during times of crisis because correlations change—and in times of crisis different asset classes tend to become positively correlated and fall in unison.

 

Is there a better way to reduce risk? We believe there is. We believe that trends clearly exist in the markets and that by being on the right side of the trend we can maximize our participation in bull markets and reduce exposure to prolonged downturns. Want to learn more? Call us today at 888-510-2362.