[In Pictures: 6 Numbers Every Investor Should Follow.]
Diversification refers to the concept of holding a variety of asset classes so that when one doesn’t perform well, the others may provide some buoyancy. For example, diversification should operate like pistons in an engine—while some pistons are going up, some are going down, but the car is moving forward.
So what’s different in today’s markets? Right now, asset classes that have historically moved independently of each other (such as domestic stocks, domestic bonds, and international securities) are moving up and down together. Uncertainty, intense investor emotions, and high volatility are resulting in unusual market behavior.
Many investors have been tempted to cut and run, moving their money into cash accounts, but I believe the current activity is an anomaly that will resolve itself in the long run. When it comes to building a solid investment strategy, a well-diversified portfolio is still the way to go.
In theory (and at its most basic academic level), a solid diversification strategy incorporates asset classes that have a low level of correlation to each other. Correlation is a measurement of how much one investment (Investment A) moves in relation to another (Investment B) and is represented by a number between -1 and +1. Positive correlations mean A & B tend to move up (and down) at the same time. If investments A & B have a correlation of +1, they move up and down exactly in step with one another in the same direction—one for one. Negative correlations mean A & B tend to move in opposite directions of one another. If they have a -1 correlation, they move in exactly opposite directions of each other.
But remember, just because assets have historically been positively or negatively correlated does not ensure that they will always act like that.
Case in point: the market’s erratic behavior since the 2008 sell-off. Asset classes that have historically had correlations of less than +1, or even negative correlations, have all been moving up and down together to a greater degree than normal—thus exhibiting short-term correlations of closer to +1 than normal.
That’s a reason why even diversified portfolios are feeling the sting in today’s environment, but that doesn’t mean that you should abandon your diversification strategy.
As always, it’s important to be aware of what’s happening right now.
Please remember, diversification does not and never will assure a profit. That said, evaluate your return requirements, appetite for risk, and requirements for liquidity against your financial plan and double check the historical correlation of the asset classes in your portfolio. If you’re on track, take the long view and stay the course with your diversified investment strategy.
David B. Armstrong, CFA, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service wealth management firm. Monument Wealth Management is backed by LPL Financial, the independent broker-dealer and Registered Investment Advisor. David has been named one of America's Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 and 2010, based on assets under management) and has been interviewed by several national media sources over the past several years. Follow David and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth and @DavidBArmstrong, and on their Facebook page. Securities and financial planning offered through LPL Financial, Member FINRA/SIPC.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. All performance references are historical and are not a guarantee of future results.