Does Diversification work the way you think it does?

Diversification: It’s a word that makes investors feel good!

As I’ve heard it said, the word rolls “sweet off the tongue.” It represents warmth of a blanket fresh out of the dryer, the scent of fresh-baked cinnamon rolls”

Per Investopedia: Diversification strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of others. Therefore, the benefits of diversification hold only if the securities in the portfolio are not perfectly correlated. If that sounds a bit like gibberish, you are reading it correctly. What is being said here is that by owning stocks in different companies and in different industries, as well as by owning other types of securities such as Treasuries and municipal securities, investors will be less affected by an event or decision that has a strong impact on one company, industry or investment type.

While this information valid, the financial industry encourages you to think of diversification as risk management, which it isn’t. (Maybe risk dilution, but not risk management)

You might recognize what happened to your stock portfolio last decade.

When you overlap the 4 major indexes in a single chart (to the right - S&P 500, Dow, Nasdaq and Russell 2000), you can see that all of these indexes tend to be marching to the beat of the same drum. In fact, when the market drops here in the latter part of 2008, all 2,630 companies (represented by these indexes) dropped in the same dramatic fashion. This a classic example of systematic risk for the equity portion of your portfolio

Did anyone else’s portfolio take a spill in 2008?

You don’t have to answer! Asset allocation alone was very ineffective at preventing catastrophic loss even in well-balanced investment portfolios...

So what's really going on here?

Contrasting the perception of a well-diversified portfolio with the reality of embedded volatility, the graph (right) reflects enormous concentration risk in short volatility. Importantly, this risk matters most at the exact point in time when one expects – hopes – their strategy of diversification will protect them. Unfortunately, the well-diversified portfolio (left side of chart) turns in to the short volatility-concentrated portfolio in periods of extreme market disruption. This can be best summarized with the popular statement that correlations on many assets behave similarly during a crisis.

Takeaway: Many investors strongly believe that holding a “diversified” portfolio of stocks and bonds will protect them in the event of a serious market correction but this is NOT the case. Whatever you do - make sure to PROTECT YOUR PRINCIPAL!

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