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+.

Financial Terms You Need to Know
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Bad News: This Time, Diversification Won't Save Your Portfolio

In a nutshell, net worth is what you get when you subtract liabilities from assets -- what you owe from what you own. Like many economic and financial terms, net worth can apply in a variety of situations.

If you're evaluating a company for your portfolio,you might glance at its balance sheet to get a handle on its net worth. Balance sheets break out assets (such as cash, inventory, and receivables) and liabilities (such as debt and accounts payable). Subtracting the latter from the former gives you net worth, which is also referred to in this context as shareholders' equity or book value.

Here's an example: As of the end of 2012, IBM's (IBM) assets totaled $119 billion, and its liabilities totaled $100 billion. Thus, its net worth, or shareholders' equity, was $19 billion.

Read more on Asset Allocation.

You probably think you've got the term down pat: Inflation means prices rising over time. Well, yes, that's pretty much right. But there's much more to inflation, and it's much more relevant to your life than you might think. Inflation can go in the opposite direction, for example, and it can spiral out of control.

Inflation is about purchasing power. It's a way to measure the changing purchasing power of our currency by tracking changes in the prices of things we buy. The national banks of various countries try to keep inflation under control through their actions and policies (such as via the interest rates they set); many aim for an annual inflation rate of about 2 percent to 3 percent.

While the concept of inflation seems simple it's actually a bit more complicated. Read more on inflation here.

Most of us are familiar with the term, and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it's a like a quantified pros-and-cons list.

Applying cost-benefit analyses in the business world and your own personal finances can be very effective, helping decision makers avoid just going with their gut or with very rough calculations.

Read More About Cost-Benefit Analysis

Simply put, it's what you give up in order to do something. Imagine, for example, that you dream of becoming an engineer or a chef. If you opt to become a chef, you give up the experience of being an engineer and all that goes with it. That's an opportunity cost of becoming a chef.

Opportunity cost is also often defined, more specifically, as the highest-value opportunity forgone. So let's say you could have become a brain surgeon, earning $250,000 per year, instead of a chef earning $50,000. In that scenario, your opportunity cost, salary-wise, is $200,000. (Of course, you should also consider factors such as your enjoyment of your chosen profession.)

Read more on Opportunity Costs.

Most folks are familiar with the concept of supply and demand, but most of us also don't give it much thought, which is a mistake. That's because it applies to much more than just business.

First, to review. In basic economics, the law of supply and demand influences prices. If supply of an item is abundant, that will pressure the price downward, and vice versa. In practice, imagine that you're the only one in town selling shoehorns. Because consumers don't have any other places to buy the product, that gives you some pricing power. But if other stores in town start carrying shoehorns, you may have to drop your price to keep customers coming.

Read about the differences of supply and demand in the stock market and in our own lives here.

As the name suggests, sunk cost refers to money that has already been invested in something, money that can't be recovered. Too often, we factor that expense into our financial decision-making when we shouldn't.

Let's say you've spent $40 on a nonrefundable ticket to the theater for tomorrow night. And you're suddenly invited to play board games at a friend's house that same evening. You might think that you should go to the theater -- after all, you spent that $40 -- even though what you'd rather do is hang out with your friends and play games. The $40 is a sunk cost. It's spent, whether you go see the play or not, and the money doesn't know the difference. So you should do whatever you would rather do.

Read more on Sunk Cost.

In the most basic sense, asset allocation is simply how one's assets are divided among different asset classes, such as cash, stocks, bonds, real estate, and so on -- even insurance investments, commodities, collectibles, and other categories count.

But the term also refers to an investment strategy -- one that can reduce risk through diversification.

Clearly, having all your money in any one asset class can be risky. In 2008, the S&P 500 plunged 37 percent. If you'd held all your assets in an S&P 500 index fund, your net worth would have taken a big hit that year.

Given the harrowing ride we've been on in recent years, you might think that holding cash is the best way to protect your assets from outside forces. Think again.

Continue reading about Asset Allocation.

The concept of interest is familiar to most of us. We know that with many bank accounts, for example, we earn some interest -- though it's rather paltry these days.

But there are several kinds of interest that are calculated and represented quite differently than simple interest. Compound interest is -- pardon the pun -- one of the more interesting ones.

First, let's start with simple interest. Here's how it works: Let's say that you've parked $1,000 in an account somewhere, earning 10 percent per year in simple interest. In year one, you'll collect $100, bringing your total to $1,100. Great, eh? In year two, you get... $100. That brings your total to $1,200. In year three, you're at $1,300. You're probably catching on to the idea by now. You keep earning that interest rate off your initial principal.

Enter compound interest, which is far more exciting.

Continue reading on Compound Interest.

The meaning of the term varies depending on context. In the accounting world, for example, it refers to the change in a company's cash level over a specific period of time. If a company's cash level rises during that period, it's exhibiting positive cash flow. If it shrinks, negative cash flow.

When investors study companies to see if they might be good fits for their portfolios, they may assess "free cash flow." That reflects a company's cash flow from its operations after it pays all its expenses. Free cash flow can be viewed as the lifeblood of a company.

Read more on Cash Flow.

When it comes to financial matters, we all know what risk is -- the possibility of losing your hard-earned cash. And most of us understand that a return is what you make on an investment. What many people don't understand, though, is the relationship between the two.

The relationship between risk and return is often represented by a trade-off. In general, the more risk you take on, the greater your possible return. Think of lottery tickets, for example. They involve a very high risk (of losing your money) and the possibility of an extremely high reward (the giant check with lots of zeroes). Or penny stocks: They're also very risky and yet seem full of amazing potential.

At the other end of the spectrum are options such as a savings account at your bank, or buying government bonds. They're quite low-risk, but you're not going to make a mint on them, either -- at least not these days, with interest rates so low.

Learn more about Risk and Return.

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