Does Diversification Actually Work?

Diversification is a widely used term in investing, but with different meaning to each investor. Financial advisors use the proverbial ‘don’t put all your eggs in one basket’ example to convey the benefits of spreading out your bets. It is intended to give investors the warm and fuzzy feeling that their portfolio will not loose as much as the S&P 500 Index in a bear market. But should this traditional method of diversification really make investors more comfortable? Is the goal of not loosing as much as the S&P 500 Index that high of a bar?

Most investors attempt to diversify their portfolio by asset class. They invest in some equities, sprinkle in some fixed income and add dash alternatives or commodities. This seems like a good strategy since some asset classes tend to zig while others zag, which will theoretically reduce the overall portfolio volatility. The theory contends that various asset classes are supposed to be ‘uncorrelated’ and move in different directions. During bear markets and economic downturns, investors rely on this diversification to protect their portfolios. However, in reality, correlations between asset classes typically rise during periods of market crisis and diversification doesn't provide the intended benefit when portfolios need it most.

So why doesn’t this definition of diversification work? It’s much too simplified. Picking a few asset classes that aren’t truly uncorrelated will not necessarily reduce volatility and protect portfolios during periods of market crisis. Diversification needs to be considered on a much more granular level to provide the intended benefits.

At Algorithmic Futures, we develop portfolios of trading strategies where diversification is considered not only by the market traded (equity, fixed income, volatility), but also trading style (mean reversion, momentum, relative value), holding period (minutes, hours, days, weeks), time of day (at the open, mid-day, near the close), and trade structure (long, short, tight stop losses, let winners run). By considering a broader array of factors, portfolios actually benefit from diversification to reduce volatility and drawdowns, with the ability to perform well during bear markets and market corrections.

The average investor has more options than plain vanilla mutual funds and stocks. Investors can utilize all the research and algorithms that Algorithmic Futures has developed to trade their capital more efficiently. In the past, only very wealthy investors had access these types of strategies via hedge funds. Fortunately, the financial markets have become more democratized for the main street investor with better options to generate returns in bull markets or bear markets.