Diversification Works, Except When It Doesn’t

It’s the first rule of investing. Keep your assets spread across various investments to mitigate downside risk. Traditionally, investors have followed a simple 60/40 portfolio design. This strategy means holding 60% of your portfolio in stocks and 40% in bonds. Different factors influence these two groups. Therefore, a drop in one doesn’t necessarily precipitate a drop in the other. Diversification is a simple strategy that works. The only problem? Sometimes it fails investors.

Markets can become volatile as seen by the Great Recession. During periods like this diversification begins to lose its effectiveness. Recent research from BlackRock determined that “increases in volatility are often naturally related to increases in correlations.” Why would heightened correlations be a problem for investors? When different investments start to behave in a similar fashion risk increases. Factors driving down one investment will have the same effect on another.

The same body of research from BlackRock illustrates that during the two significant bear markets of the Tech Bubble (2000-2002) and the Great Recession (2007-2009) “correlations between many individual investments and even asset classes spiked.” This phenomenon presents investors with a problem: diversification is least effective when it's needed most. Imagine a fire extinguisher that risks exploding in warm environments.

For example, during the Great Recession, international stocks exhibited a correlation of 0.93 to mid-cap stocks. A perfect correlation is 1.0 meaning that these two classes moved in near lockstep with one another.

What’s the solution?

The researchers suggest turning to alternative investments. This strategy can bolster diversification, so a portfolio can withstand dramatic market downturns. Commodities like precious metals fit into this category. Major institutions like Harvard and Yale have discovered the value of allocating a portion of their endowment to these alternative investments. In fact, over the past 25 years, both schools have increased their exposure to alternatives which also include instruments like futures and short positions.

The research supports their strategy. During the recession, the S&P 500 Index experienced a drawdown of 50.9%. This dramatic fall means that the index needed to deliver a return of 103.9% just to recover lost ground. However, the Dow Jones Credit Suisse Index, which includes alternatives, lost just 19.7% in the same period requiring only 24.5% to recover. What increased by 25.63% during this period? That’s right, gold surged.

During a major market downturn, alternatives make a difference.

Many investment instruments lumped into the “alternative” category are complex and speculative. Examples of these esoteric offerings include derivatives, convertible assets, and global macro strategies. Therefore, investors must be comfortable with the terminology and mechanics of the methodology. However, commodities like gold offer an easy (and easy to understand) way to begin capturing alternatives in one’s portfolio. Including this one additional asset class in a basket otherwise consisting only of stocks and bonds can have a measurable impact on risk.

Today central banks are starting to remove support thereby elevating risk. Make diversification work by including more asset classes and ensuring that when the market falls your portfolio stays afloat.