The Death of Diversification

"Wide diversification is only required when investors do not understand what they are doing." - Warren Buffett

The above quote from Warren Buffett flies in the face of convention.  Armies of financial planners and legions of schools all teach the same thing, diversify, diversify, diversify.  It is the only way to protect your assets.  Diversification (investing in numerous asset classes or spreading your wealth among many investments to limit the risk of any one asset destroying your portfolio) is the tool used to protect your nest egg against disaster.  If something goes down then something else is probably going up and this will average out to a positive rate of return.  Don't put all of your eggs in one basket in case you drop that basket.  All of this is very prudent advice but recently I have questioned this as it relates to the stock market.  At present there seems to be a high correlation between all stocks which gives it the feeling of being manipulated.  In other words, all stocks seem to move together rather than based on their individual merit. 

Now while I agree that there will always be some correlation between assets that are fairly similar in nature there should be some benefit to a diverse portfolio of stocks. This however does not seem to be the case.  In the past a portfolio of stocks would be spread among sectors and classes.  The idea was that an oil company was not in any way related to a technology company so buy some of each would just expose you to market risk and not sector or stock specific risk.  Further diversification into small cap stocks and large cap stocks also increased your diversification as they seemed to move to the beat of different drummers.  However with the invention of Exchange Traded Funds (ETF's) anyone with a pulse can drop a few dollars into an ETF and buy the whole market.  It is cheap, easy and you do not have to fight with your financial planner over which asset class to buy.  This lead to a boon in ETFs as the wire houses invented more and more of them.  Nowadays you can buy an ETF for anything even if you bet the market will go down.  In fact you can lever this up three times by buying the 3x bear fund!

The problem with these products is that they have all but eliminated stock diversification as a tool to protect your portfolio.  A new study showed that since 1998 correlations between stock classes has closed from almost 50% to virtually nothing.  Everything is moving together as swathes of money blindly buy an ETF which in turn blindly buys the underlying stocks with no thought to value or sector.  With the removal of this benefit it jeopardizes most portfolios as the supposed protection is gone.

Furthermore in other studies it has been shown that just when diversification is needed most it disappears.  The time diversification is required is when there is a market melt down however it has been shown that during market downturns, most, if not all asset classes fall together removing the safety net right when you miss the trapeze.  Just think back to 2007 and trying to find an asset class that actually went up!

Review your strategy and make sure that you are not overly exposed to stocks as if and when people start to dump their ETFs everything will go down together and this time it looks like it will be worse than before.  Think outside of the box and look to alternative asset classes as this is the only remaining way that your portfolio can be protected against the next downturn.