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How can you diversify when so many investments are heading in the same direction, writes MoneyShow's Howard R. Gold, who points out why this happened in the first place and where to look for real diversification now.

Don't put all your eggs in one basket.

There's some truth behind that cliché: Some investments zig when others zag, so by diversifying, you reduce your potential losses and lower your risk. That's why Nobel Prize-winning economist Harry Markowitz called diversification the only free lunch.

But what if all the baskets are floating in the same direction, and the only one that isn't … is filled with rotten eggs?

That's the problem many investors face now. Risky assets, like stocks, commodities, and real estate are moving in lockstep. Only long-dated bonds are swimming against the tide, and nobody wants them because of fears the Federal Reserve will eventually stop its massive bond buying and raise interest rates.

So, the choice appears to be throwing even more money into stocks, which are nearly five years into a bull market, or buying bonds, which we know will go down in price. Or keeping more in cash (with its negative real return), or stuffing money in the mattress. Or, God forbid, buying leveraged inverse ETFs as a hedge.

The problem is correlation. For those of you who, like me, snoozed through your stats classes, correlation is, according to Investopedia, “a statistical measure of how two securities move in relation to each other.”

The closer you get to a +1 correlation, the more the two securities or asset classes move together. The closer you get to -1, the more they're going in opposite directions.

Uncorrelated assets provide real diversification. But finding them is difficult now, as you can see from the following tables, reprinted with permission of the Center for Applied Research (CAR) at State Street (STT).

From 2003 to 2007, commodities and 20-year Treasury bonds were the only asset classes negatively correlated with the Standard & Poor's 500 index (SPX). Frontier markets and US corporate bonds had only a slight positive correlation, providing some diversification.

chart
(Click to enlarge)

But that's all changed since 2008.

Correlations between the S&P 500 and all other risky assets have soared, making a mockery of research that showed investing in asset classes like commodities and real estate helped balance out your stock holdings.

According to CAR, from 2008-2012, nearly every risk-oriented asset class (global stocks, real estate, hedge funds, and private equity) moved well-above a 0.8 positive correlation with the S&P, and commodities weren't far behind.

chart
(Click to enlarge)

But note how 20-year Treasuries' correlation plunged to -0.63, as close to an ideal negative correlation as you can get in the real world. Remember how Treasuries soared in 2008, while stocks plummeted? Long Treasuries and, to a lesser extent, investment-grade corporate bonds became the world's safe havens.

Why did this happen?

Why did this happen? Surely, the loose monetary policy of the world's central banks has played a big role. The Fed alone has added nearly $3 trillion to its balance sheet since the financial crisis began.

Richard Bernstein, the former chief investment strategist at Merrill Lynch, who now runs Richard Bernstein & Associates in New York, told me: “As interest rates have gotten lower and lower, the hurdle rate … has gotten lower and lower, so more asset classes have gotten acceptable to investors.”

“The point of monetary policy has always been to lower rates to get people to take more risk,” he continued. “When everybody's into everything, there's no…risk assessment. Everybody throws caution to the winds.”

Suzanne Duncan, global head of research at State Street's CAR, cited global market integration as another cause of diversification's decline, saying, “During a period of crisis, markets move in tandem.” And apparently after the crisis as well.

Also, big institutions have moved away from traditional stock-and-bond portfolios to embrace alternative assets from hedge funds to private equity to timber land. But now those hedge funds (which have $2.5 trillion in assets) are desperately trying to find alpha by fighting over the same turf.

Meanwhile, high-frequency traders, armed with massive computer power arbitrage, moved away from market inefficiencies in milliseconds.

That's left virtually nothing into which average investors can diversify, except what they don't want to buy — long U.S. Treasuries, which now appear to be in a secular bear market.

Since peaking on July 25, 2012 (when the ten-year Treasury note hit its all-time low yield of 1.38%), the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) has lost 20% of its value while the S&P has soared about 30%.

And yet buying long Treasuries is what real diversification would demand. “Diversification is an insurance policy,” Bernstein told me. “If you were 100% sure the stock market was going up, why would you diversify?”

But if you were 100% sure long bond prices will fall, would you buy them anyway just for diversification's sake?

I wouldn't. I recommend that people keep only 40-50% of their holdings in stocks, which means still owning lots of bonds. But I sold my long Treasuries a while ago, and I've shortened the maturity of the rest of my bond holdings. I wouldn't buy long Treasuries again until rates go much higher.

“Over the long term, diversification works,” explained Duncan. “The most diversified portfolio enhanced returns by 70% on a risk-adjusted basis,” she added, citing CAR's studies.

Genuine diversification sometimes means owning what you hate. But most investors would rather have a sundae than eat their kale. Kale may be good for you, but it tastes bitter. Ice cream is yummy.

That, in a nutshell, is why real diversification is so hard these days.

Source: Why Diversification Isn't Working Now