Diversification is Dead. Long live Diversification

Don’t give up on diversification through asset allocation just yet

A short introduction to asset allocation and diversification

Assets allocation is said to be the optimal investment method for household investors. As household investors we lack both the time and knowledge to handpick assets and build and maintain a long term investment portfolio on our own. Unless you have a significant enough portfolio brokers and financial consultants will also professionally manage your portfolio through one asset allocation or another.

Asset allocation relies on diversification and the benefits it presents. If finance diversification is aimed to lower the specific risks of an investment and capture only the market risk, which cannot be eliminated. Specific risks are the risks associated with a single investment and include the risk the company we invested in will lose a major client, for example, or lose their successful CEO.

Diversifying is aimed to maximize the return with a given level of risk. The math behind this model is based on the correlation between the assets we invest in and this is one of the ways portfolios are built.

The bad news

If you’ve managed such a diversified and allocated portfolio over the past couple of years you must have noticed diversification didn’t quite work, to say the least. Each and every portfolio crashed and burned, regardless of the asset allocation (unless you went short on the market).

All major stock indices, commodities, oil and almost every asset that comes to mind plummeted. Diversification over assets, geographies and currencies hasn’t saved our portfolios from significant losses.

Some hoped that the emerging markets will be strong enough and independent enough to balance out the devastating impact of the recent crisis. Another economic motor would have created two semi-correlated financial drivers which might have offset some of the damages. It appears that it is too early to nominate China (and the European Union) as the next economic powers that be.

The reasons may be abundant but it seems that with globalization came increased correlation between assets and swept our precious diversification away. What are we to do now? How can household investors invest in such a turbulent market atmosphere?

Well, aside from increasing the risk free asset portion of the portfolio (such as deposits and government bonds) I believe there are also good news to be had.

The good news

First and foremost what crashed and burned together would probably rise back together. As such, anything we’ll put our hands and money on will probably generate decent returns on the upcoming investment horizon.

Some of us remember the good times back at 2005-2007 where all the assets generated decent returns and stock picking was never as needless.

Moreover, on the geo-political side of things, the increased co-dependence between our countries’ economies will hopefully lead to increased cooperation and mutual consideration of our impacts on one another.

How should households invest?

I’ve tried answering this question in my previous posts. I’m still a big supporter of good asset allocation. As I’ve written before good asset allocation includes allocation of investments over time not just over assets. Time allocation or dollar cost averaging helps us smooth the behavior of our portfolio by constantly averaging the buying price of shares and bonds.

I believe that other markets will emerge as economic engines of growth and will hopefully serve the world economy alongside the USA.

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