Friday, July 09, 2010

What diversification is and isn't

(Note: During a crash - all movements become highly correlated)

A few recent readings about the crash of '08-'09 has led me to this post. Investors wishing to diversify away from all market volatility are foolish indeed (an impossible task); it can't be done at times of violent market movement. Investors panic en-masse in those times, so traditional measures of relative correlation totally dismember.

What diversification does, is during relatively normal times, involving single stock fluctuations of 30-40% per annum (eg normal variations), is produce more stable returns during those periods. Even during some periods of somewhat greater than average relative market strength or weakness, it the chance for those non-correlations to hold together, producing those more stabilized returns, that most investors prefer.

During times of market stress or extreme giddiness, only YOU can provide the non-correlation to market averages: keeping your head about you and increasing (decreasing) your market exposure during periods of violent downdrafts (irrational exuberance).

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Neil said...

This post seems to define diversification very narrowly - basically diversifying within the confines of the stock market. Which isn't diversified at all.

Owning different assets is what provides true diversification. Government bonds do well in most crashes. Sometimes gold does well. No matter the case, money has to go somewhere when it's pulled out of the stock market.

But no matter what the diversification strategy, having the cohones to rebalance and buy the declining asset while selling the increasing one is what keeps your returns more stable.

Jay Walker said...
This comment has been removed by the author.
Jay Walker said...

Yes, Neil,

this is a worthwhile point in pursuing. Basically, I was speaking about what I call "investment assets" (ownership of a business in some form or another), rather than "savings assets" (eg cash, T-Bills, high quality bonds, etc.).

Your last paragraph hits the nail on the head.

Thanks for coming on by.