Diversification: Not the Han Solo Blaster You Thought It Was

There is a tendency among the financial elite to bless the "diversified portfolio." After all, many credit diversification as one's Hans Solo blaster against investment risk.

The idea is simple: If you spread your investments around, you won't get beaten to an inferior paper towel pulp. More specifically, the indoctrination includes using different asset types (e.g., stocks, bonds, cash, currencies, commodities, etc.), distinct investment markets (e.g., U.S., Europe, Asia, etc.) and unique market segments (e.g., utilities, technology, basic materials, etc.).

Clearly, I am not going to win awards for poking holes in the conventional wisdom of the day. For the most part, I agree with basic principles of diversification. However, the practice often leads investors towards maintaining a very false sense of security.

For instance, historically speaking, investing in commodities has meant a non-existent correlation to stock and bond markets. That has lead many to mistakenly conclude that commodity investing, in and of itself, is a great way to diversify away from the risk in stocks and bonds.

Yet a non-correlation does not mean that there is an inverse relationship such that commodities rise when stocks go down. For instance, let's say that your concept of a diversified basket meant a healthy helping of commodities, and you held the following ETFs in the last week of February, 2007:

iShares Dow Jones Large Cap Growth Index (IWF) for U.S. large caps
iShares Dow Jones Small-Cap Value (IJS) for U.S small caps
iShares MSCI EAFE (EFA) index for European exposure
iShares S&P Global Energy (IXC) for global energy demand
iShares Comex Gold Trust (IAU) for worldwide demand in the commodity

2 weeks after the February 26 sell-off, here is the approximate drawdown on the diversified portfolio:

IWF -5.3%
IJS -6.3%
EFA -5.5%
IXC -5.5%
IAU -6.6%

Oil and gold both have their merits as commodities in certain investor portfolios. Yet if the reason you have them in your account was to diversify away from stock market risk, you have been misled. Non-correlating assets may mean that investments may move in the same or opposite direction. (Note: There is a similar misperception that bonds must go up when stocks go down and vice versa... not true!)

For my part, I am very fond of certain commodity ETFs in some of my client portfolios. For example, industrial metals through the S&P Metals and Mining Index (XME) and Market Vectors Steel (SLX) have proven worthy.

That said, I do not choose these investments for the sole purpose of diversification; rather, their appropriateness is tied in greater part to the global demand for metals and materials. Most importantly, there will come a day when the investments themselves will be sold to genuinely reduce the risk of a big loss. (In fact, the big loss is the most important risk that you can avoid... and must avoid!)

Disclosure statement: Some of Pacific Park’s investment clients may hold positions in any of the investments mentioned above.

Comments

[Beta Hog]

Some good 'educational' points, some perhaps not so strong ... the 'evidence' over a 2 week interval is a bit short to my mind ...