Asset Allocation: The Key to Proper Diversification

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The above chart represents the return for nearly every combination of equity investments you could have made over the last year. No sector, style, world region or market cap escaped devaluing more than 25%. Now, compare this to the start of our last recession between 2000 and 2001.

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Just within U.S. equities, proper diversification likely could have avoided 40% losses caused mainly by one sector. And, in fact, it was eminently possible to find a safe haven sector (ironically, financials) to hide from the carnage.

While The Curious Investor and most investing blogs focus mainly on equity investments, the past year has taught us that the old adage, “There’s always a bull market somewhere,” is not always the case for the equity markets. Or, is it?

Diversification is more than buying stocks in different industries and geographies

Risk comes in many types. Diversification through different companies and industries can help to insulate you only a few unsystematic risks namely industry risk, company specific event risk, and geopolitical risk. To properly diversify, you need to consider investments outside of equity markets - asset allocation.

Asset Allocation with a Brokerage Account

It can be difficult for retail investors to access non-equity assets. Most brokerages offer some access to U.S. Treasuries and other government or municipal bonds as well as a small amount of corporate bond placements. These can often come with significant fees or minimum investments, but there is a more cost effective route. Ironically, these investment vehicles trade through typical stock exchanges. Just as The Curious Investor has previously discussed using ETFs and ETNs to create hedges and passive indexing, it’s possible to use ETFs and ETNs to gain access to assets outside of the markets.

For me personally, given the state of our economy and the likely pressures on the U.S. dollar because of policy actions to remedy the situation, I’m interested in adding commodity exposure (click to check out my rationale on gold and oil) and foreign bond exposure. It just so happens that there’s an ETF for all these purposes - iShares COMEX Gold Trust (IAU), iPath S&P Crude Oil Total Return Index (OIL), and iShares S&P/Citigroup International Treasury Fund (IGOV) (and more if you look around). While the IGOV was brought to market less than a month ago, data for IAU and OIL show correlation of .20 and .33, respectively. That’s about as uncorrelated as a risk asset can get and exactly what you’re looking for when properly diversified.

Disclosure: None

Comments

[Prudent Man...:]

All stocks and most bonds are speculative, regardless of the, obviously shabby, ratings. Pre- restructured AT & T, GE, GM, etc. were, at one time not so long ago, considered riskless. For those of us who got a good financial education and not a prestigious degree we learned better.

Most people do not have the assets, temperament and/or time to properly invest in stocks. Profits and growth are not an entitlement for governments, citizens or businesses. Anyone who has not learned that in the past six months never will. Furthermore, drill into any ETF you buy and watch for conflicts of interest by insiders who basically construct the ETF.

Feb 16 06:20 PM

[cma:]

"proper diversification likely could have avoided 40% losses caused mainly by one sector."
Wrong, your own statistics show that only retrospective "proper diversification" could have reduced losses. If one had a market weight with "proper diversification" one would have lost 40% +.

Feb 16 07:36 PM

[The Curious...:]

Not sure if I wasn't clear. But, in the sentence that you quote, I was referring to the 2000-2001 recession. The lesson taught to us in 2000-2001 was not to be overweight one sector. The lesson learned this time around (2008-2009) was more than that. It was that just being diversified within an asset class is not enough to insulate your investments from catastrophic draw downs. That's why I'm advocating looking outside of just equities (U.S. and global) and diversifying into other asset classes.


On Feb 16 07:36 PM cma cma wrote:

> "proper diversification likely could have avoided 40% losses caused
> mainly by one sector."
> Wrong, your own statistics show that only retrospective "proper diversification"
> could have reduced losses. If one had a market weight with "proper
> diversification" one would have lost 40% +.

Feb 16 08:49 PM

[couldashoulda:]

My asset allocation model for the last year:
"If it ain't goin' up, don't buy it.. Nothing is goin' up so dont buy anything..'cept gold.. maybe

Feb 17 04:34 PM

[granger:]

good stuff, well said


On Feb 17 04:34 PM couldashoulda wrote:

> My asset allocation model for the last year:
> "If it ain't goin' up, don't buy it.. Nothing is goin' up so dont
> buy anything..'cept gold.. maybe

Feb 17 05:17 PM

[DrewS:]

"It is important to note that the great claim of asset allocation relates to the risk reduction achieved by diversifying over several broad asset classes (i.e. stocks, bonds, cash and real estate) without a similar reduction in return. However, the risk reduction is strictly theoretical (typically based upon relationships that existed over a particular period with no guarantee that these same relationships will continue in the future). This is the crux of where asset allocation or modern portfolio theory breaks down. Risk is not defined; instead it is merely expressed in historical standards." - Randy Swan 1997 Swan Consulting, Inc

Feb 18 12:45 PM