Bad News: This Time, Diversification Won't Save Your Portfolio

One of the fundamental rules of investing is not to put all your eggs in one basket. But even investors with diversified portfolios haven't gotten the results they wanted from their investments lately. Rather than counting on diversification to work under all circumstances, you need to look closely at what's happening with the markets and the economy now to see if the odds are against you with the particular mix of investments you own. Otherwise, you could face the surprise of seeing every part of your diversified portfolio hit the skids at the same time.

Part of the problem can be traced to a relatively new strategy designed to help investors diversify their investment exposure: risk parity. As a recent Wall Street Journal article described, risk-parity funds work by trying to make risk levels equal across different types of investments, including stocks, bonds and commodities. Because bonds have historically carried less risk than stocks and commodities, the risk-parity strategy involves using leveraged bond positions -- essentially, borrowing money in order to buy a greater number of bonds.

Advocates of the strategy argue that by offering true diversification across three asset classes, risk-parity funds are appropriate for conservative investors who want to earn respectable returns on their investments no matter how the financial markets are performing. But since the beginning of May, financial markets have gotten a lot more turbulent, and that has spelled trouble for the strategy that risk-parity funds use.

In particular, although stocks have seen swings in both directions, bonds, commodities and other investments have seen significant declines over the past two months. Rates on long-term Treasury bonds have risen by nearly a full percentage point, and that has sent their prices plunging, with some long-term bonds losing more than 10 percent of their value since early May. Metals like gold, copper, and aluminum have also suffered price drops of between 5 percent and 15 percent. Even when stocks began their own correction in mid-June, bonds and commodities didn't provide any ballast to offset stock-market losses.

When Relationships Among Investments Break Down

The recent behavior of financial markets is fairly unusual. Often, when bond prices fall, it's because the economy is performing better, which in turn bolsters prospects for businesses and leads to rising stock prices. Conversely, when the stock market falls, many investors take the proceeds from their share sales and invest in Treasuries and other bond investments, sending bond prices higher.

Lately, though, the intervention of the Federal Reserve and other central banks has disrupted that traditional relationship. Stocks, bonds and commodities have all gained from the Fed's loose monetary policy, with freely available credit boosting prices of assets throughout the economy. But now that investors are eyeing the prospect of central banks reversing their monetary policies and reducing the volume of liquidity they're pumping into the global economy, stocks, bonds and commodities have headed back down.

The result for risk-parity funds has been substantial losses from what investors expected to be low-risk investments. Among the many conservative investment institutions that had jumped on board the risk-parity trend: pension plans, whose health in general was already shaky before these recent losses.

Beware of 'Low-Risk' Investments

Diversified funds might offer less risk than a highly concentrated portfolio of stocks or other investments, but there's no strategy that works in every market environment. The best you can hope for is to identify the situations in which a given diversified strategy will fail and then make your own assessment of the likelihood of those situations actually occurring.

You can follow Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.

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July 05 2013 at 10:27 AM Report abuse rate up rate down Reply

What does Joe Bogl say about this?

July 04 2013 at 9:45 PM Report abuse rate up rate down Reply

Horse Races. Get a job Wall Street, and do something friggin useful! Of course, some people thrive by being parasites...

July 03 2013 at 2:53 AM Report abuse rate up rate down Reply
Don E

The real reason diversification won't work is that "ENTIRE" stock market is greatly overvalued!

July 02 2013 at 4:49 PM Report abuse +4 rate up rate down Reply

Only a fool invests with borrowed money.

July 02 2013 at 4:30 PM Report abuse +3 rate up rate down Reply

Proper diversification will protect you from market downturns, but it will also shield you from market upturns. Theoretically, a "perfectly" diversified portfolio will return the market rate of interest. Add a little risk, and your returns go up and your losses go up. How do you beat the market? Obviously by predicting the future. Otherwise, it's luck..

July 02 2013 at 1:43 PM Report abuse +1 rate up rate down Reply

Bonds purchased at VERY low interest rates with long-term maturity (10+ years) are a sucker's bet. Historically low interest rates are NOT historically supported as lasting. Unless you are happy earning a couple of percent for 10, 20 or 30 years and intend to hold those bonds to maturity you should expect a principal loss - if you hold a couple percent yield bond to maturity you will probably loose too - unless there is deflation, which the Fed will fight more (it's doing it now) than inflation.

Stocks with a strong track record of paying dividends with yields above 2.5 - 3.5% and strong balance sheets / market positions are the safest bet for income producing investments (and capital gains). The richest people in the world have gotten there by investing in a few, less than a dozen or so, investments - look at Buffet, Bloomberg, Gates, etc. Almost none of them are anywhere near as "diversified" as so-called investment "gurus" would advise you - they don't make any money off you if you buy a few solid stocks and use DRIP and hold them Long-term. They make money off of mutual fund fees. The only rich diversified people are the guys that sell the mutual funds themselves...not the buyers of the funds (unless they were rich already).

Pick 3 or 4 "necessary" industries for most of your money, then pick 2, 3 or 4 solid companies in each and buy those. Oil & Gas, Food/consumer, drugs & Tech/Communications are 4 GREAT industries. In oil and gas (APA, CQP, DUK & SDRL), in Food (CAG, POT, MO), in Drugs (LLY, NVS) in Tech/Comm (VZ, CTL, INTC) - I own(ed) all of these, and while they were down during the recession, they are back up, but the key is they mostly paid dividends like clockwork. And only sell when it gets to a very high valuation (up 100%+) and I find something else in that category they pays a nice reliable dividend and has potential for price appreciation. If it jumps big (25%+) in a short time frame I may sell and take the gain - but I have to have another stock in mind to replace it...otherwise I hold and take the dividend.

Once you have established a solid base, like above, then you can take some risks with other shares looking for capital gains - buying down stocks of good companies or emerging ones. You should not try to manage the whole market - pick a few stocks in a few industries and follow them closely. I would only look for capital gains with about 10 - 15% of my portfolio value at most.

My philosophy prescribes to the notion that you NEVER spend your principal and you reinvest dividends into more shares that pay a dividend...sure at some point later in retirement you may need to spend principal but if you have been adding to it thru DRIP over the years/decades, chances are you will generate enough dividend income in retirement to turn off DRIP and just take the dividends in cash for enough time to ensure you can delay or never touch (spend) the principal.

July 02 2013 at 12:21 PM Report abuse +2 rate up rate down Reply

Typical Huff propaganda.

July 02 2013 at 12:10 PM Report abuse +1 rate up rate down Reply

buy solid companies with a history of paying dividends over a long period of time

July 02 2013 at 10:48 AM Report abuse +6 rate up rate down Reply
Mike Dever

Diversification is the one true "Free Lunch" of investing. But if a person starts with just considering long stocks, bonds (including inflation-indexed bonds) and real estate as being the only portfolio options, then true diversification cannot be achieved. I discuss this throughout my book "Jackass Investing: Don't do it. Profit from it." (which has been the #1 Amazon Kindle best-seller in the mutual fund category).

My approach to diversification is quite different from conventional investment wisdom. One concept I think you'll find most interesting is in that I replace asset classes with "return drivers" and "trading strategies" (as I point out in the book, asset classes are simply long-only trading strategies that do not attempt to disaggregate their many separate return drivers). Once viewed in this fashion it is easy to create a truly diversified portfolio, rather than one constrained by the shackles of asset classes.

I'm pleased to provide a complimentary link to the final chapter of the book, where I present the benefits (greater returns & less risk) of a truly diversified portfolio:

July 02 2013 at 8:18 AM Report abuse -1 rate up rate down Reply