Is Diversification Dead?

Smart investors have long built diversified portfolios in order to protect themselves from catastrophic losses. Historically that worked well, as gains from winning investments tended to offset losses from others.

Yet more recently the effectiveness of diversification has been on the decline. Later in this article, I'll give you some ideas on what to do to respond to this troubling trend. But first let's take a closer look at exactly what has happened to the alternative investments that once worked so well as a hedge against stock market declines.

The theory behind how a diversified portfolio improves risk-adjusted returns makes a lot of intuitive sense. If you own just one stock, then you take on a huge amount of risk. No matter what happens to the overall market, what happens to that single company will make or break your finances. Adding more stocks to your portfolio, however, makes each one less important to your overall returns, giving you a smoother ride and more stable returns in the long run.

Many investors have taken the same view with their overall asset allocations. Rather than sticking with a traditional combination of stocks and bonds, you can now easily add a wide range of more exotic investments, ranging from commodities to emerging-market debt and real estate investment trusts. One selling point for these alternative assets is how they've historically traded fairly independently of stocks, adding to their value as diversifiers.

But over the past several years, those correlations have increased dramatically. As figures from a Fidelity Investments study show, monthly returns on commodities have gone from being almost not at all correlated with stock market returns to a correlation figure of 0.6, suggesting a fairly strong relationship. Meanwhile, REITs and emerging-market stocks have seen their returns move even more closely with the stock market, greatly reducing their value as diversifying investments.

Fidelity argues that one reason for the increase in correlation stems from the financial crisis. As investors saw the risks that the crisis introduced, they realized that all financial assets share some systemic risks. Recognizing those common risks led investors to treat them more similarly.

But as I see it, the proliferation of exchange-traded funds and other trading vehicles for alternative assets were the main spark that boosted correlations. Consider these examples:

Since its inception in late 2004, the SPDR Gold Trust (NYS: GLD) has gone from owning a mere $115 million in gold bullion to its current holdings of $68.9 billion. iShares Silver Trust (NYS: SLV) for silver, along with similar vehicles for other commodities, has also seen stratospheric gains in assets.

Mortgage REITs have existed for a long time, but they've gotten a lot more massive in recent years. Annaly Capital (NYS: NLY) had only 124 million shares outstanding at the end of 2005, but now that number has risen nearly eightfold to 970 million. An even more extreme example is American Capital Agency (NAS: AGNC) , which has gone from about 24 million shares just two years ago to more than 224 million at the end of last year.

Investing in emerging-market bonds used to be solely the province of Wall Street master-traders. But now, both iShares JPMorgan USD Emerging Markets (NYS: EMB) and WisdomTree Emerging Markets Local Debt have billions of dollars under management, making it simple for average investors to get the exposure they want.

Diversification means standing out from the crowd. In order to do that, you have to avoid investing in exactly the same way as everyone else. Fool analysts have hammered that message home in the emerging-market arena for years now, revealing the risk that concentrated ETFs create in emerging markets. But the same argument applies anywhere you see large amounts of money chasing the same investments.

The good news is that if you're willing to do your own thinking, you can stand out from the crowd without too much trouble. It takes some work, but in the quest for a safer portfolio, it's worth looking for undiscovered investment opportunities to help boost your returns and get more diversified.

Picking individual stocks can help greatly in that quest. Let me invite you to take a close look at the Motley Fool's special report on long-term investing, where you'll find three promising stock picks that can help you reach your financial goals. It won't cost you a thing, but don't wait; get your free report today while it's still available.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitterhere.

At the time thisarticle was published Fool contributor Dan Caplinger tries to stay as diversified as he can. He has a diversified portfolio that includes many of these alternative asset classes, but he doesn't own shares of the specific companies and ETFs mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy lives on.

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