Wednesday, April 15, 2009

Diversification and Correlation During Market Crisis Periods

One factor that has been painfully clear in this market downturn is the high correlation of nearly all asset classes. The result for investors is nearly all the asset classes experienced significant declines during the recent market contraction. So what is the purpose of diversification if it does not minimize the negative portfolio returns during stress market periods? The answer begins with the question as to what are investors trying to diversify.

During periods of market stress there tends to be two factors that influence the price of investments:
  • there is a flight to quality and
  • a high demand for liquidity
This flight to quality and demand for liquidity causes investors to flock to the safest investments. For fixed income this tends to be government bonds and for equities it tends to be high quality equities. These high qulaity equities tend to be large cap blue chip dividend growth stocks.

A recent paper by Barclays Global Investors titled, Is Diversification Dead?, provides more detail on the conundrum for investors as it relates to the diversification issue.

Is Diversification Dead
In the end though, it is difficult to predict when the market will experience these significant drawdowns. For investors, building the foundation of the equity portion of their investment portfolio in high quality dividend paying stocks is one way to potentially gain some assurance they will not experience significant market value erosion in market downdrafts.

As I have written several times before, when the market rallies off of a bottom during these corrective phases, the higher quality equity investments will likely lag the broader market returns though.


Mark Wolfinger said...

If diversification is not the end-all be-all that it was supposed to be there is a much simpler remedy. And sadly, it's been ignored by essentially 100% of financial planers and nearly all stockbrokers.

Options. Conservative option strategies allow hedging - and that means risk reduction. That beats diversification anytime.

I recommend the collar strategy for the most risk adverse, but there are alternatives.


Jonathan said...

Tough topic.

I believe diversification is a nice alternative for someone that is not "that" active.

For someone who likes swing trading, diversification can be a killer as you won't "maximize" your winners.

It's a point of view. =)