Is Diversification Worth It?

| August 10, 2010 | 0 Comments

How do you feel about adding pork belly futures to your portfolio?  How about Bolivian government bonds?  Hey, the investment experts are always telling us how important it is to diversify…

But is diversification even really worthwhile?

The short answer… it all depends on how you diversify.

First off, let’s talk about what diversification means.

Basically, diversification is mixing a variety of investments in a portfolio. The idea is different types of investments won’t all move the same direction at the same time.  It should result in a better average return with lower risk than any single investment.

You see, it’s all based on this statistics concept called correlation.

Correlation is simply a measure of how two investments move in relation to each other.  What does a tech company do when a financial company trades higher?  Does it go up, down, or do nothing?  Or take the bigger picture.  How do wheat futures move relative to treasury bonds?

I’m not going to bore you with the details of how correlation is calculated.  Suffice it to say, it’s a tedious process to do by hand.  (However, anyone can calculate correlations with a spreadsheet and a list of historical prices.)

But the calculation isn’t what’s important… it’s the result.

It doesn’t matter what investment products you’re comparing.  The result will always be a number between -1 and +1.

Let me explain…

Two investment products with a +1 correlation move exactly the same way.  Let’s say Ford (F) and General Motors (GM) have a correlation of +1.  If one moves up 5% in a day, so does the other.

A correlation of -1 is the exact opposite.  Using the previous example, if Ford goes up 5%, GM goes down 5% at the same time.

Finally, a 0 correlation shows there is no relationship between two investments.  In our example, the movement between Ford and GM on any given day is totally unrelated.

Generally, correlations will fall in between -1 and +1.  The closer the correlation is to +1, the more positively correlated investments are to each other.  And of course, the opposite is true with negative correlations.

So why is correlation important to you?

The basic gist is to build a portfolio of investments which don’t have a correlation of +1.

You see, if the investments in your portfolio are positively correlated, they’ll all move the same direction at the same time.  That’s nice when everything is going up… but pretty awful on the way down.

In theory, you should be able to put together a portfolio which has close to a 0 correlation.  It’s supposed to be possible by mixing stocks, bonds, commodities, and real estate.

But here’s the thing…

In the recent market crisis, all investments correlated positively with each other.  In other words, everything went down together.

In reality, there isn’t a whole lot you can do when the market freefalls.

About now you’re probably wondering if diversification is even worth it. What’s the point if you can’t protect your downside?

There are a couple of different answers to this question…

First of all, over the long-run, diversified portfolios perform better than non-diversified ones.

Well diversified investments should be safer.  For example, a diversified portfolio may lose 25% in a bad market.  But, the non-diversified portfolio could lose 90%.

But here’s the key…

You need to diversify the right way.

In the past few years, you’re no longer seeing the benefits of diversification if you’re holding a bunch of equities… even if they’re all from different sectors.  And it’s not just sector differences.  Foreign versus domestic.  Small cap versus large cap.  None of it’s true diversification anymore.

Let me give you an example of why this isn’t an effective way to diversify…

The correlation between large cap companies and foreign equities is .93.  No joke.  You might as well put your money all in one company…

And real estate isn’t much better.  The correlation between real estate and large cap companies is currently a mind-boggling .84!

Don’t worry.  There are better ways to diversify.  And it’s pretty easy to do.

Not every asset class moves the same as equities.  Bonds are a reasonable way to diversify.  They only have a .27 correlation to large caps.  (Times have changed.  Bonds used to be negatively correlated to equities.  Don’t let your financial advisor tell you otherwise.  Though it’s a low number, bonds are still positively correlated to equities.)

Another idea, buy the CBOE Volatility Index (VIX).  The VIX has a -.65 correlation to large cap equities.  Remember, negative correlation means it moves the opposite of the large caps.  That’s an excellent way to diversify.

Simply stated, you can find effective ways to diversify your portfolio.  All you need to do is a little research.  Start by looking up correlations between different investment types.

The bottom line is it’s worthwhile to diversify.  Just make sure you do it the right way.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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