In a continuation from our previous post, I wanted to discuss what diversification means to you.
The most commonly used example is the S&P 500 Index. According to Ibbotson Associates, the S&P 500 (with dividends reinvested) has lost money 14% of the time over a 5 year period. If you stretch the time period out to 10 years, it has lost money 4% of the time. And a 15 year time frame does not show any negative returns. So, as long as you hold the stocks long enough, your risk goes down. Correct?
Not necessarily so says Mark Kritzman. The scenario above showing positive return over the long term indicates an ability to withstand severe market downturns in the interim. As we talked about in the post "Fat Tails and Black Swans", it is possible to underestimate the impact such events can have on your overall portfolio. In fact, the longer you stay 100% invested, the higher your risk is that such an event will have an detrimental impact on your portfolio.
The solution? Diversifcation thereby your hedging risk. No that does not mean exotic derivative instruments, it means sound Strategic and Tactical allocation models. Gather investments with very low & negative correlation. These are assets that will, theoretically, not track each other that closely - if at all. A sound strategic approach.
However to best limit risk, you should also consider the Tactical side. This is because correlations change. The correlations are the best measure of the market over the long term, however, periods of significant market decline can lead to increased correlation between assets. Not good.
Attention should be given to asset classes that can diversify in a down market. This does not mean that your entire investment policy should be based unique events, but a certain awareness of these facts can help limit potential losses so you can maintain a certain level of wealth.
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