Portfolio Diversification Still Works!

 When was the last time you examined your portfolio allocation? If it's been more than a year, the rising stock market may have up-ended your original asset allocation decision.

Never really decided on an asset allocation? Oh my! Now is the time. 

You don't have any control over the investment markets. You can't control the returns your portfolio earns... but you CAN control 

• How much you invest
• Your asset allocation (% allocated to stocks vs. bonds, domestic vs. international, etc. and
• How much you pay to invest
  

Amy C. Arnott, CFA explains why diversification is important. 

https://www.morningstar.com/articles/1031277/why-portfolio-diversification-still-works

What is diversification and why does it matter? 

There are many asset categories where an investor can park their money. Categories include stocks, bonds, cash, domestic and international securities, including commodities, corporate bonds, global bonds, high yield, REITs (real estate investment trusts), and Treasury Inflation-Protected Securities, among others.  

The correlation in the returns on these various assets vary from very high to very low.  

A diversified portfolio will reduce volatility (wide swings up and down) and limit losses during market downturns.  

You want a portfolio with assets that have LOW correlation with each other so that when domestic  stocks are doing poorly your international bonds might be doing well. 

"Correlations often tend to increase during periods of market stress, making portfolio diversification tough to find when investors need it most. This pattern held true in early 2020 as many major asset classes (except high-quality bonds and cash) moved in tandem during the coronavirus-driven market downturn. And over the past 20 years, correlations have edged up for several asset classes, including commodities, corporate bonds, global bonds, high yield, REITs, and Treasury Inflation-Protected Securities." 

"Diversification has often been called the only free lunch in investing. As Harry Markowitz first established in his landmark research in 1952, a portfolio’s risk level isn’t just the sum of its individual components but also depends on correlation, or how the holdings interact with each other. Correlation is a statistical measure that ranges from 1 to negative 1 and captures how two securities move in relation to each other (although it only captures the direction, not the magnitude, of those movements)."

"Combining asset classes with correlations below 1.0 reduces the portfolio’s overall risk profile. It's one of the few cases where the whole can be more than the sum of the parts; a well-constructed portfolio can have better risk-adjusted returns than its component parts alone."

"While diversification doesn't work with every asset class in every market, it's still an important tool for improving risk-adjusted returns over the long haul."