Diversification beneficial, but not foolproof
By Russ Wiles
Arizona Republic
You can run but you can't hide.
Even well-diversified investors learned that the hard way in recent months, when foreign stock markets failed to provide much protection against faltering domestic prices.
Global diversification is supposed to provide a cushion and an overall smoother ride since foreign stocks respond to different economic variables compared to their U.S. counterparts. But it doesn't always work that way, at least to the degree shell-shocked American investors would like.
If anything, the correlation or movement between U.S. and foreign stocks has risen in recent years, reducing the benefits of diversification. This reflects increased economic integration around the globe and closer trading ties among stock markets in different nations.
Correlations tend to rise even more during market shocks like the credit-crunch fallout late last year and earlier this year. At such times, traders tend to react to the same news and developments, and often face the same constraints like a sudden lack of liquidity.
"When extreme events happen, trading all goes in the same direction," said Peng Chen, chief investment officer and president of Chicago researcher Ibbotson Associates during a recent review of diversification strategies.
In short, you can't assume a well-diversified portfolio will bail you out of every jam. But you also shouldn't conclude diversification is worthless. With recent high market-volatility, here are some portfolio-building tips for putting it in perspective:
The trend is toward more global integration and higher correlations, as Chen noted, yet stocks in other nations still don't move in perfect tandem with U.S. equities. Nor do individual stocks or firms in different industries, whether here or abroad, move in lockstep. As long as stocks behave somewhat differently, you can expect a bit smoother ride in your portfolio from diversifying.
Then again, diversification shouldn't be your sole motivation in venturing abroad, as foreign stocks also provide the potential for faster growth and higher gains.
Unlike equities around the globe, the link between stocks and bonds has grown less direct in recent years, said Chen, reflecting in part the 2000-2002 bear market when bonds held their ground while stocks got pounded. Fixed-income assets thus continue to provide diversification help, especially if you layer in various types of bonds, such as corporate, government, high-yield and foreign, supplemented with money-market or other cash instruments.
As painful as the housing slump has been, real-estate investments also help diversify a stock-based portfolio, Chen said. So do various commodity assets such as precious metals, industrial metals, oil, gas, food, lumber and so on. You can invest easily in such areas by purchasing shares in mining and other commodities companies or mutual funds that invest in them.
