A problem facing individual investors stems from the notion that diversification of investment is a starting point for a sound investment strategy. Does diversification need to be a de facto component of an individual investor’s philosophy and strategy?
Diversification is a focus when investing based on the assumption that spreading risk provides a net benefit in ones portfolio management. Greater diversity leads to reduced downside based on the assumption that all investments are not moving in lock-step with one another.
The real question that needs to be answered is how tightly correlated are markets with one another. If ‘diverse’ markets have a high correlation, then diversification is a mirage. This is true for many markets. In the last major down turn in the markets nearly a decade ago, almost all markets depreciated greatly in value. In a few areas, such as precious metals, appreciation was seen. Otherwise, it was an all-out race for the exists throughout most investments.
If we look at the 2007-08 market meltdown as a data set, then we see that markets became highly correlated during the crisis. If you were in the U.S. or international equity markets, things moved down together. Being in one or spread out did not make a difference. As the market came out of the crash, markets began to become less correlated. (Source: http://store.ectap.ro/articole/629.pdf)
Over the last decade the explosion of exchange traded funds and their increased use by investors has been a driver to correlate the market, too. The widespread use “leads to buying and selling respectively of all the constituents of the indices tracked by the funds. This means that stock prices move more closely together.” Source (https://www.ft.com/content/5a40b6a8-d176-11df-96d1-00144feabdc0) In short, if more and more people are buying baskets of stocks, then groupings of stocks become more like one another in price movement.
If diversification should not be a cornerstone of every individual investors strategy, then what principles should be our guide? The development of rules that govern how one buy and sells should be the corner stone. Highly correlated markets need to be seen as a loose partnership. They are with us to make us money. They are not with us to hold throughout our entire life on the assumption that markets always appreciate over the long-run.
Where do we get in? Where do we get out? These are the two primary questions that should govern our market engagement or disengagement. If markets are moving together, then the precision of selection loses value. Some markets will shine more than others, though if conditions are bullish a general lift will be seen across the entire landscape. If thing are bearish, the opposite will hold true. To be a wise investor, it is paramount that an on/off mechanism be defined to handle the bullish times and the bearish times. Especially since bearish times in recent memory have equated to equity markets falling together.
Multiple strategies exist and can be further developed to handle when to be in the market and when to be out of the market. One of the more simple strategies is the use of the 200 day simple moving average (SMA). A moving average provides an average market price based on the prior trading days considered. In a 200 day SMA, the average reflects 200 prior trading days of activity. If the market is above the moving average, the sentiment is typically considered bullish. When a market is below the average, then in general things are considered bearish. Various factors can change these generalities, which go beyond this conversation.
The 200 day SMA is widely used market throughout the investment community. It is a general signal and therefore has been built into most platforms. The measurement is built into charts from Yahoo! Finance to actual broker account terminals. This SMA is truly simple in its accessibility.
When considering your investment strategy, do not assume diversification means safety. While markets might be highly correlated, the correlation between diversification and safety can and has been eroded by history’s stark truth.