How Diversification Dies

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Diversification is not what it used to be.

Investors have long understood the safety of a diversified portfolio. Over the decades, more investors have opted for low-cost mutual funds and exchange traded funds which give them exposure to hundreds of stocks in a single share.

But is this strategy truly diversified?

Some measurements suggest the answer is no. In recent years, a greater portion of the S&P 500’s performance has been due to a shrinking cohort of stocks.

This is hard for some investors to believe. After all, the S&P 500 is up approximately 26% this year. Take a closer look and it’s clear that this impressive performance is not the norm for most companies within the S&P 500. Consider that about 84% of the companies within the index are trading below their 52-week highs. This fact begs the question: if the majority of stocks in the S&P 500 are under their high water mark then why has the index performed so well is 2021?

The reason is that “the S&P 500 is a very top-heavy index,” explains the Chief Investment Strategist at CFRA Research. This presents risk for investors who participate in a stock-only investment strategy as stock valuations rise. The disproportionate performance of the stocks within the S&P 500 index presents risk to investors that might believe they are more diversified than they are.

This problem is only intensified by the fact that the performance of different assets is becoming more correlated. Research published in the paper The Global Rise in Cross-Asset Correlation shows “a rise of cross-asset correlation between select asset classes.” The research reflects “an average correlation increase of 33% between the test periods 1990-2000 and 2006-2016.” This heightened correlation is a problem because, “a significant market event or correction can be compounded by a period of highly correlated assets across integrated financial markets.”

Today a major market event appears more likely as the Fed signals impeding rate hikes which could impact the stock market.

The situation is challenging because investors face the dual problem of stock index movements that are due to a small number of companies, and the fact that even other asset classes are becoming highly correlated.

The good news: gold offers some measurable relief from these two challenges. Research from State Street in cooperation with the World Gold Council found that “gold has had low or negative correlation with major equity indices since 2000.” Their research also shows that gold has a low, or negative correlation to major bond indices.

Importantly, the research also shows that allocating 2%, 5%, or 10% of a portfolio to gold can improve the Sharpe ratio which is a number that rises as the risk/return balance of a portfolio improves.

Diversification is not dead, but it is not what it used to be. The strategy of diversifying is still a good one, however, many believe that they are diversified when they are not. This is due to an imbalance of performance in the S&P 500 and the rise in correlation between different asset classes. Consider gold as a hedge.

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