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Diversification is not enough.

Are you diversified? Many investors might have thought so. But at the end of February when the Shanghai index fell by more than 8%, almost all markets fell 3-6% in sympathy – leading investors to believe that diversification no longer works. In fact, it’s more important than ever. But diversification is not enough.

Global markets are more closely linked today. Large multi-national companies routinely get 50% or more of their revenues from non-domestic activities. What used to be 3rd world countries look more like underdeveloped markets which grow into developing markets which mature into developed economies. Trade expands and countries become more inter-twined and inter-dependent. Canadians know this as well as anyone. With so much of the Canadian economy dependent on U.S. economic health, when Americans sneeze, Canadians catch a cold.

The close relationship between countries and economies means that globally, stock and bond markets are also more closely linked. In portfolio manager babble-speak, there is an increase in correlation across global asset classes. Closer correlation means, as a risk manager, it is more difficult to insulate a client’s portfolio with traditional diversification. When all markets move together, traditional diversification is not enough.

True – in the short-term.

Longer-term, the case for diversification is stronger than ever. Economies and markets are influenced by money supply, credit conditions and economic growth which, in turn, influence currency changes. These and other factors impact different economies and markets by different amounts at different times.

Because economies tend to grow over time, investors should always have some level of exposure to financial markets to ensure participation in that growth. Traditional diversification allocates to stocks, bonds and cash. This is bedrock – the ultra conservative core of a portfolio. The core exposure is adjusted to underweight an overextended market or overweight an undervalued market. Exposure is reduced or expanded – never zero.

Now recall 2000 to 2002. Stock markets were brutal and bonds alone didn’t deliver. Even the FPX Balanced index returned -0.99%. A stretch like this can test an investor’s staying power.

When traditional core diversification is not enough, investors can look to non-correlated assets (other than traditional cash, bonds and stocks – like Gold or Asian bonds, for example).

Non-correlated assets (also called alternatives or satellites) can provide critical down market offset to traditional core diversification – because they tend to zig should the core zag. Satellites complement rather than replace core holdings.

Even with this type of core-satellite strategy, individual positions within a portfolio will perform differently at different times. Investors should expect these positions to be more volatile than their portfolio overall. A portfolio view, however, means it matters less what happens to the individual positions. The gains in one asset offset or help to moderate declines in other assets. In fact, it’s this blend of exposures that is the heart of portfolio theory – and the value of diversification.

Traditional diversification, complemented with non-correlated assets, will help to smooth the ride through a down market.

Originally published in the Business Thompson Okanagan news, April 2007 and the Business Fraser Valley news May 2007.

Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.

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