Dear Investor, We all know we need to diversify. It may be the single most frequently repeated item of investment wisdom. Actually, though, that may be a problem. It’s been repeated so often, it’s easy to wind up allowing the advice to go in one ear and out the other without really thinking about what implementation is really all about and why we need to do it; aside from avoiding accusations of being a bad person. Those who check the textbooks, whether on their own or as part of a finance class, will read of such concepts as volatility, standard deviation, covariance and correlation. Readers are led to expect that they’ll be able to protect against declines in Asset A by also owning Asset B, which goes up whenever Asset B goes down.
In textbook examples, such relationships occur all the time. In real life, more often than not, as Asset A declines, Asset B also declines but we hope it won’t fall as much (or, heaven forbid, more than) Asset A. But even that often winds up little more than a wing and a prayer. It’s not like you can learn anything by looking at objective data. Correlation among pairs of assets is remarkably unstable over time, so the lawyers and regulators are spot on when they tell us about past performance not determining future outcomes. And actually, the situation is worse than mere statistical crunching suggests. Due to globalization and years of easy money, correlations have been rising and are likely to continue to do so (making historical correlation data, the only kind we have, even less effective in pointing us toward the sort of diversification that can mitigate risk). So please do not give credence to anything you may see or hear that purports to demonstrate how effective well-diversified stock and-bond portfolios have fared. That’s really an area where we should expect much higher correlations in the future.
But if we can look at diversification without getting preachy and without flexing our statistical muscles, we can see a different aspect of the topic and how it really is a great way to manage risk. We’ll do so by looking at, you guessed it, low-priced stocks. Individually, you have to know how risky these are. I’ve felt it. I have to assume you have too.
