Does diversification work?
Date posted: December 30, 2010
Diversification — or putting your investment eggs in many baskets — has long been recommended as a core investment principal. But with so much turmoil in recent years in financial markets, does diversification still work? N.C. Cooperative Extension economist Mike Walden responds.
“Well that’s an excellent question, … and it’s one that many financial analysts are asking. For diversification to work you have to have low correlations between the different investment types — meaning that they don’t all move in the same direction at the same time. That allows diversification to work because the premise is that, for example, if stocks are going down, if you have a diversified portfolio, something else in your portfolio will be going up. That’s what it means for those investment types not to be correlated.
“The problem is in the last couple of years we have seen the investment types move towards correlation. They have all been moving in the same direction. Stock market went down, housing market went down, for example. And so this is causing some investment analysts to scratch their heads and say, ‘Gosh, is diversification still something we can bank on in the future?’ And the big question is whether the switch in correlation from the investment types not being correlated to them being correlated — is this a temporary change or a permanent change?”
Category: Economic Perspective