BULLS & BEARS: Why diversifying may not accomplish what you think

July 23, 2007

What is the one thing nearly every investment adviser, financial planner or grandpa would tell you is the most important attribute of a solid portfolio?

Diversify. In other words, don't put your eggs in one basket-right?

It makes perfect sense to any rational

person and is almost a religion among some in the financial-planning community.

Planners use fancy-schmancy software to "optimize" asset allocation and will plot your portfolio vs. "the efficient frontier" in order to fine-tune your risk and potential reward.

Because nobody knows where the next hot market will be, wise folks tell you it is necessary to spread your money around.

Their mantra is, you should put some in U.S. stocks, some in European and Asian stocks, emerging market equities, gold, industrial commodities, bonds, T-bills, foreign currencies, etc.

Nowadays, the well-heeled are even diving into private equity funds and hedge funds.

The whole theory is that these various markets aren't correlated, so one will zig while the other zags.

Not only that, but markets have different rates at which they gyrate; some, such as Chinese stocks, zoom around like bottle rockets, while others plod along like oxen.

This gyration rate, or volatility, is called beta.

The effect of the gyrating zigs and zags is that a well-constructed portfolio will, in theory, give you smoother "efficient" returns-and help you sleep better at night, too. But in the real world, U.S. stocks, European and Asian stocks, emerging market equities, gold, industrial commodities, bonds, T-bills and major foreign currencies are becoming ever more correlated.

They are all zigging together.

Look at a five-year chart of any of the above indexes and every one looks almost the same: U.S. stocks, up 80 percent; the EAFE (Europe, Australia, Far East) index, up 100 percent; emerging markets, up 200 percent; gold, up 100 percent; raw materials, up 150 percent; oil, up 100 percent; and the Euro, up 70 percent.

There isn't a zag among them!

Since correlation is increasing, diversification is not reducing your risk as much as you may think.

Warren Buffett had a good take on risk during the Q&A at his last shareholder meeting.

He said, "Volatility does not measure risk. It's nice math, but it is wrong. Risk is not knowing what you are doing. If you know what you're dealing with, and know the price you should pay, then you are not dealing with a lot of risk."

Buffett went on to say, "We have invested in a lot of sectors that have high betas. Since stock prices jiggle around, finance professors have translated that into investment theories. The development of beta has been useful to people who want careers in teaching."

Are you diversified to reduce risk? Oops, wrong question. Do you know what you are doing, know what you are dealing with, and know the price you should pay?

If you answered no to those questions, diversification might not be enough to give you a good night's sleep.



Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, a money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.
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