In 2022, Diversity, Equity, and Inclusion (DEI) seem to dominate the discussion in politics and corporate America, but let’s not forget that financial advisors have diversified their clients’ portfolios since the advent of Modern Portfolio Theory back in 1952! Buying different mutual funds, ETFs, and asset classes can make us feel diversified, but we should also explore correlation and how it affects diversification and portfolio performance. How can we apply these measures of risk used by institutional investors to our portfolio?

Counting the number of holdings in a portfolio and ensuring no one holding takes up a too-big share of the pie can determine the most basic level of diversification. By spreading out investments over many companies, a saver reduces the risk that the bankruptcy or failure of any one company will result in financial ruin for that saver. By this measure, the S&P 500 is well diversified, and the Russell 3000 is even more diversified. Most people know they should not put all their eggs in one proverbial basket.

However, company stock prices can suffer substantial losses even if the company is nowhere near bankruptcy. Although well diversified, the S&P 500 and Russell 3000 experienced double-digit declines this year. It didn’t even help to own the S&P 500 or the Russell 3000 because they both went up and down simultaneously. These coincident moves in price imply a strong, positive correlation between the indices. Modern Portfolio Theory goes far beyond counting the number of holdings by analyzing the correlation among holdings in a portfolio and favoring non-correlated investments, or those that go up and down at different times than the others, or those that zig when others zag. These investments march to the beat of their drum.

Even this advanced statistical analysis has limitations because it only looks backward at historical data, which doesn’t help us predict the future. How do we know if we have sufficiently diversified our portfolio for the uncertainty of what’s to come? As a conservative fiduciary, I recommend assuming that any investment not guaranteed by the government will have a strong positive correlation with everything else in a big selloff. By this definition, the only true diversifiers are Series I bonds, FDIC-insured savings accounts and CDs, and short-term Treasuries. Ensuring sufficient funds in these safe assets not only dampens the hit to the overall value of your investments in a down market but also provides the security that breeds confidence to take appropriate risks in other parts of the portfolio. Would your portfolio pass Diversity Training?

Tune in next month to see how environmental and social issues like DEI should or should not play a role in your portfolio construction!

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