Diversification: When It Doesn’t Work

The most common description of diversification is to not keep all of your eggs in one basket. However, Andrew Carnegie, steel magnate of the late 1800s, had a very different philosophy regarding diversification, “keep all your eggs in one basket and then watch that basket very carefully.”

Carnegie was mighty successful, having made so much money by age 65 that he sold out and spent the rest of his life giving his money away. The 2,509 libraries built with Carnegie’s money are a testament to the success of his undiversified style of business.

I’ve been helping clients with their money for 4 decades. Along the way I began to take a contrarian’s view of many Wall Street adages because most of them lead to ruin if followed blindly. Rules of thumb are generalities. They are not always right. And Murphy’s Law of Investing tells us that things will be different when the difference is most expensive. This is very true for diversification.

The goal of spreading money out over many categories is to find investments that go up and down at different times. The technical term is “un-correlated” markets, whose returns are unrelated so the likelihood of all of one’s investments going down at one time is reduced. Common sense stuff.

Correlation studies of various investment groups such as stocks or bonds, domestic or foreign, financial assets or commodities are normally done over long periods of time. But market declines are usually short, nasty affairs. The problem for diversifiers is that when markets go down sharply, normal correlations disappear and everything goes down at once. Everything! When you need diversification to work the most, it works the least.

I track 70 different classes of investments in my Adaptive Strategies software. In the two weeks from May 10th to May 24th, literally every class of investment suffered losses. Stocks had their sharpest decline in many months. Gold had it’s largest sell-off in 15 years. Oil, real estate, European stocks, even the darlings, China and India, got hammered. There was no place to hide. And, being highly diversified didn’t help, it just meant that you would have taken losses in many more places.

The May 2006 decline, although I think it has a couple of weeks more to run at this writing (May 26th), is pretty tame compared to the massive 2000-2002 bear market that saw many investments lose half of their value. Then, like now, there were few places to hide.

When this happens we play defense for our clients who have Adaptive Market Strategies accounts. We take steps to preserve principal values in those portfolios. Moving to a money market fund is a good defense in market declines. Money market interest starts to look pretty good when you compare it to a minus something. And we also increasingly hedge against declines with “inverse” funds, investments that work backwards. They go up when a market goes down. This is being aggressively defensive – trying to actually make money in market declines.

Clients with our special Adaptive Market Strategies accounts have seen a lot of activity in their accounts these past few weeks as we hedged and moved to cash. Plus they can sleep well knowing their money is being watched every day. If you don’t have an actively managed Adaptive Market Strategies account (you know if you do because there is a fee involved) and would like this level of service, please give me a call.

I think Andrew Carnegie would like knowing that we do watch carefully.