New Money Rules for Financial Security - #6. Diversification

[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]

One of the basic money rules about a portfolio was that it had to be diversified to reduce our risk of losses. Well all of us know that diversifying our portfolios did not stop us from losing money in the recent downturn of the stock market. What went wrong?

Rule #6: Diversification

Old thinking: A diversified portfolio lowers your risk.

New rule: Diversification won't always save you - and you need more of it than you think.

Our take: Our experience shows that diversifying our portfolio did not hedge our losses which was a whopping 50%. It is a popular notion that we should diversify with international stocks to minimize risks against poor performance of US stocks. Well it's common knowledge that both U.S. and foreign stocks are deep in the red.

Investing in commodities was thought to be a good hedge against risk of loss from poor performance of the U.S. stock market. Unfortunately, commodities are in the red too.

Now since stocks have tanked, all the money is flowing towards U.S. Treasuries aka bond market. This has resulted in a bond bubble which is at its peak now. It is one of the worst times to invest in bonds since you will be buying at one of the all time high prices. According to the theory of diversification if we turn the dial of our investments towards bonds now, we would be buying them on high (or at peak). Thus subsequent returns from these investments in future would be low.

Over a very long period of time diversification might work out well. But from our investing experience, we have found that instead of complementing each other, diversified instruments are moving in sync for the last couple of years!!

Jeremy Grantham, chief investment strategist at GMO, observed back in 2007 that we had a bubble not just in one or two kinds of assets, but in risk. Investors around the world were so confident, and so hungry for even a little extra return, that they were throwing money at anything that might deliver. Now that the risk bubble has burst, all those investors want now is the safety of U.S. Treasuries. So everything has moved roughly in sync, both up and down, for a few years.

Here is a chart showing the performance of VTSMX (Vanguard Total Stock Market Index) with respect to BIV (Vanguard Intermediate-Term Bond ETF), BLV (Vanguard Long-Term Bond ETF) and BSV (Vanguard Short-Term Bond ETF) in the time frame of April 20, 2007 to May 22, 2009.

Please click on the image to zoom in for a better view
If you study the chart, you will notice how Vanguard's indexes tracking the U.S. stock market and bond markets (short, intermediate and long) are flowing in sync. For each index, troughs and peaks are occurring at about the same time :(.

Question

What are your views and experiences about diversification with respect to keeping your financial security intact in the immediate present? We are looking forward towards your feedback.

Series

New Money Rules for Financial Security
» Rule #1 - Handling Risk
» Rule #2 - Building Cash Savings
» Rule #3 - Earning Potential
» Rule #4 - Handling Debt
» Rule #5 - Home Equity
» Rule #6 - Diversification
» Rule #7 - Retirement

Image Source(s): iStockPhoto

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