The real deal on portfolio diversification

One of the key precepts of modern portfolio theory is to diversify, diversify and diversify some more. The basic idea is this: a portfolio drawing from widely divergent asset classes tends to have less price volatility. In other words, as some assets fall in value others will rise over any given period of time.

That’s the theory. Making this work in practice is another matter. Fidelity Investments has outlined straightforward steps investors can take to diversify their portfolios and they aren’t too mysterious.

  1. Stocks: No one issue should make up more than 5% of one’s equity portfolio. Make sure you have exposure across different industry sectors, geographies and market capitalizations.
  2. Bonds: Aim for a broad mix of fixed income investments with varying maturities, markets and sensitivities to interest rate changes and inflation fluctuations.

Things get more complicated when one tries to assess the correlation of broad assets that make up a portfolio: stocks, bonds, real estate investment trusts (REITs), commodities and hedge funds. Portfolio managers aim for a mix of investments that are uncorrelated or tend to behave differently depending on market conditions.

In the investment world, correlation is a measure of whether two investments head in similar directions or diverge. A measure of 1, means both assets move perfectly in lockstep in the same direction; a reading of negative 1 signals the investments move in opposite directions.

The challenge for investors is to track and reassess correlation behavior among various asset classes. A particular asset class that has behaved one way historically relative to other investments can shift direction over time or even quite suddenly.

One of the most intriguing debates among portfolio managers these days is whether “alternative investments” such as commodities, REITs and hedge funds have lost their diversification characteristics since the 2008-2009 financial crisis.

A study by the Leuthold Group, an institutional research firm in Minneapolis, that analyzed market data going back to 1994 revealed that the correlation of returns from funds that tracked commodities, REITs and hedge funds had increased relative to stocks since 2009 through 2013, according to the Wall Street Journal.

In addition, a working paper (pdf) published by the Bank for International Settlements in July reported a higher correlation between stocks and commodities after poring over market data from 1980 through 2012. Since the financial crisis, “the correlation between commodity and equity returns has substantially increased,” according to the BIS working paper.

The takeaway point here is this: correlations between asset classes are in a constant state of flux and can shift abruptly. In its diversification guide, Fidelity published an interesting chart outlining how asset classes converged during the bear market that extended from September of 2008 to February 2009.

The burning question among portfolio managers is whether the recent convergence between alternative investments and stocks is a one-time fluctuation or the beginning of a long-term trend.

A recent report by Barclays Research titled “Untangling commodity correlations” cited here suggests that commodities are starting to diverge again from stocks and may soon regain the reputation this asset class enjoyed before the financial crisis as a hedge.

The bottom line: Portfolio managers and investors need to keep reassessing the correlations among asset classes in their portfolio. Regular portfolio rebalancing that takes into account changing relationships between, say, stocks and commodities is considered a best practice among money managers and investment firms.

Investors should also stay abreast of the latest research on asset classes that figure prominently in their portfolios.  Asset diversification is a praiseworthy goal; achieving it consistently takes a lot of work.

Nothing mentioned in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security.  Past performance is no guarantee of future results.

The post The real deal on portfolio diversification appeared first on Smarter InvestingCovestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures.