3 Reasons Traditional Asset Allocation Doesn't Work

The key is to invest in non-correlated asset classes.

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We've been taught not to put all our eggs in one basket or in financial terms, not to have too much invested in one stock or one fund. These old adages tell you what not to do, but they don't tell what to do. Let's look at diversification and asset allocation with some ideas on how to make it work in your favor.

Many people think that if they hold several stocks or mutual funds they have solid asset allocation. That simply is not the case. Diversification is about having different assets in a portfolio. It's important to the note that while a portfolio may have many different assets, they may all have the same asset classification. For example, if an investor holds ExxonMobil, BP, and Gulf in a portfolio, that person is diversified, but all of those stocks are of the same asset class. If the market for oil stocks is crashing, then all of those oil stocks are plummeting as well. True asset allocation is not about having different assets. It's about having different asset classes. Oftentimes different asset classes react differently in the various market cycles, which is positive. This differing reaction to the various market cycles is called correlation, and it's much more important to hold assets that are not correlated rather than having stocks that are simply diversified.

[See Diversification: Can You Have Too Much of a Good Thing?]

It has become much more difficult to find non-correlated asset classes. This is true especially in the global markets. The primary reason is that many of the largest companies in the world have become global in their reach. Think of it this way: When you can buy a McDonalds cheeseburger or a Starbucks coffee in virtually any city across the globe, these companies are no longer simple domestic entities. They are global companies and react in the global market. You no longer get the same level of diversification by investing in a domestic stock and an international stock because it's highly possible that they move in the same exact way through the various market cycles. Remember, the best thing for a truly diversified portfolio is to have assets that react differently as the markets change. That different reaction is what can lower risk and even raise return.

The best way to overcome this globalization issue is to look for non-correlated global investments. Using things like currencies, commodities, global real estate, and global bonds is a great start to significantly diversifying your portfolio.

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Most investors are not aware how to invest in those varying asset classes. They do not know how to invest in a currency or how to obtain a global bond in their portfolio. The fact is that there are many retail investments that are now available to all investors through mutual funds and exchange-traded funds (ETFs).

[See U.S. News's top-rated world bond funds.]

Ultimately, true diversification comes from a portfolio built from more than a few stocks. It comes from having a number of investments that are non-correlated through the global markets. You then have access to many of those asset classes through both mutual funds and ETFs. However, research is necessary.

Good luck and happy investing.

Kelly Campbell , Certified Financial Planner and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Fairfax, Va. Campbell is also the author of Fire Your Broker, a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.