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.

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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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