Di-ver-si-fi-ca-tion

  1. the act or process of diversifying; state of being diversified.
  2. the act or practice of manufacturing a variety of products, investing in a variety of securities, selling a variety of merchandise, etc., so that a failure in or an economic slump affecting one of them will not be disastrous.

Above is the Webster’s Dictionary definition for diversification.  I guess it says what it is – and what it aims to do – but the big question is, “Does it actually work?”  After all, Wall Street, most investment professionals, and almost ever TV commercial having to do with retirement planning touches on the topic of diversification.  Therefore, it must be the answer to all your risk!  <sarcasm>

As the saying goes, “A picture is worth a thousand words,” so I’m not going to have to add much commentary here.  See for yourself…

Below is a chart that shows the performance of a bunch of different investments (Large, Mid, Small-cap stocks, international stocks, and bonds) from 2000-07.  Notice how each investment moves differently over the course of time.  So it looks like diversification works, right?!

diversification-in-an-up-market

Source: “Investing with the Trend,” by Greg Morris

Not so fast.  The above chart is the result of this “diversified” portfolio in an up-market.  Below is the same, exact basket of investments, but instead of observing their performance during a bull market, this is how they look during a market crash:

diversification-in-a-crash

Source: “Investing with the Trend,” by Greg Morris

Notice how almost all (every investment except the bonds, in the top frame) tend to move very closely together.  This is the single biggest issue with Modern Portfolio Theory (MPT), the basis on which the Buy & Hold investment philosophy is based.  U.S. stocks, international stocks, and bonds tend to have varying correlations when markets rise, but when markets crash, most of these “diversified” investments tend to correlate closely with one another, obliterating the entire point of behind diversified to begin with (i.e. – to manage downside risk in your portfolio).

Nerds note: 

Correlations coefficients range from -1 (inversely correlated) through zero (no correlation what-so-ever) to +1 (perfectly correlated).  The purpose – or theory, I should say – of diversification is to buy different investments that do not correlate with one another, in hope that the “spreading out” of this risk will protect you from large losses during a market crash.

The first thing most investors miss is what you just learned, above… that diversification “works” during up-markets, but not so much in down-markets.

The second thing they miss is what diversification really is:  The management of money in a way that actually reduces risk, which includes, but is not limited to:

  1. Implementing protective stop losses
  2. Using cash/money market as an asset class instead of being invested “all in, all the time”
  3. Not being afraid to overweight non-traditional investments (i.e. – commodities, currencies, and hedging).

So I think we accomplished what we sought out to do today – to determine whether diversification is a valid tool for protecting your money from market crashes.  One of my mentors used to say, “Diversification is the fastest way to average gains and average losses.”  I’d say he was correct.  Maybe diversification is fine when the market is going up, but it’s just “di-worse-ification” when it’s going down?  We provided you with the facts – you be the judge!