What Is Diversification, and Does It Work? – Part 3

by financialmom on September 24, 2010

in Diversification, Investing, Investment Philosophy

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(This is a guest post, with content written by Symmetry Partners, LLC.   Our firm utilizes Symmetry Partners, LLC for investment management services.)  Part 3 finishes the series on diversification with the concept of correlation.

It may help you to look at the picture of a DNA helix – the two main strands are moving opposite of each other, which would be how two asset classes would look if they were negatively correlated, one moving up while the other moves down (Keep reading and it will make more sense.)

Correlation

While correlation may be an unfamiliar concept to many investors, the science behind it has been with us for more than half a century and is elegant in its simplicity.

Two securities whose prices tend to move in the same direction over time are said to be correlated to each other. Conversely, two securities that tend to move independently of each other over time have a little or no correlation to each other. And finally, two securities that move in opposite directions over time are negatively correlated.

Logically, a well diversified portfolio of investments should be comprised of securities that exhibit a low correlation to each other, and securities from different asset classes tend to display this attribute. In our opinion, a low correlation between the securities in a portfolio tends to benefit investors as we believe it typically results in a higher return for the amount of risk that the portfolio is assuming.

Benefits in Real Life

So where can we see the benefits of broad diversification in a real life environment? One needs to look no further than the decade that spanned the years 2000-2009; a period some refer to as “the lost decade.”

Burton Malkiel, Professor of Economics at Princeton University, and a firm believer in the power of diversification, summed up the benefits of being broadly diversified during this difficult period as follows:

“If you were in U.S. stocks alone, you ended the decade with less money than when you started, but if you diversified, you did very well…  The rest of the world is growing faster than we are – in particular emerging markets. If you had diversified broadly across markets, across the world, and with some bonds as well as stocks, you actually ended the decade with about twice as much money as when you started.”1

The lesson learned? Diversification appears to be alive and well, yet to experience the benefits, we believe it must be practiced wisely.

1 Fox Business, August 30, 2010

New Profile Pic 2599R What Is Diversification, and Does It Work?   Part 3Pamela Otten is CEO of Pamela Otten LLC, a Registered Investment Advisor. She loves to work with women business owners and entrepreneurs, and women in transition due to job change, death, or divorce. Pamela will help you set and reach your financial goals, educate you to understand your investments, and teach you how to do more charitable giving. Pamela is a Qualified Kingdom Advisor (www.kingdomadvisors.org), trained and committed to integrating biblical principles with her investment advice.

cc smallest What Is Diversification, and Does It Work?   Part 3Photo Credit – mira66

Financial Planning, Investment Advice, and Investment Management provided through Pamela Otten LLC, Registered Investment Advisor.

The opinions voiced in this material are for general information only, and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, please consult your financial advisor prior to investing.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.  Diversification does not ensure against market risk.

Content written by Symmetry Partners, LLC. Our firm utilizes Symmetry Partners, LLC for investment management services. Symmetry Partners, LLC, is an investment advisor registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. All data is from sources believed to be reliable, but cannot be guaranteed or warranted. No current or prospective client should assume that future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this article will be profitable. As with any investment strategy, there is a possibility of profitability as well as loss. Please note that you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Symmetry Partners.

The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as investment advice or a recommendation of any specific security. Past performance does not guarantee future results.

Higher potential return generally involves greater risk, short term volatility is not uncommon when investing in various types of funds, including but not limited to: sector, emerging markets, small & mid-cap funds. Risks for emerging markets include risks relating to the relatively smaller size and lesser liquidity of these markets, high inflation rates and adverse political developments. Risks for investing in international equity include foreign currency risk, as well as fluctuation due to economic or political actions of foreign governments and/or less regulated or liquid markets. Risks for smaller companies include business risks, significant stock price fluctuation and illiquidity. Real estate investments are affected by changes in real estate values, property taxes, interest rates and regulatory requirements and are subject to heavy reliance on cash flow and concentration in a small number of projects or single sector. Investing in higher-yielding, lower-rated bonds has a greater risk of price fluctuation and loss of principal income than U.S. government securities, such as U.S. Treasury bonds and bills. Treasuries and government securities are guaranteed by the government for repayment of principal and interest if held to maturity.

Diversification seeks to reduce volatility by spreading your investment dollars into various asset classes to add balance to your portfolio. Using this methodology, however, does not guarantee a profit or protection from loss in a declining market. Mutual funds are sold by prospectus only. Investors should carefully consider objectives, risks, charges and expenses carefully before investing. The fund prospectus contains this and other important information. Investors should read the prospectus carefully before investing. For a copy of the prospectus contact your financial advisor.

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