Diversification is one of the best risk-mitigating strategies people can employ in their portfolios. This is obviously not a new technique and, in fact, may seem quite simple in concept. However, some investors can find the application rather difficult to employ, or they ignore it completely in their search for high returns. But, the truth is that no one knows the future, and anyone who tells you otherwise should be avoided. Mitigating risk is the sensible choice and including investments that are not correlated to each other is one way to accomplish this. When investments are perfectly correlated they will have a correlation of 1. In this case, they will move in exactly the same manner when certain market events occur. However, uncorrelated investments (correlation of 0), will always have random behaviors when compared to each other. It is also possible to have investments negatively correlated (-1), in which their responses are perfectly opposite each other all the time.
Understanding the investment correlations within your portfolio is important to verify that you are accomplishing the diversification strategy that you have set out to implement. You might have a wonderful selection of securities, but when you evaluate their correlations, you find they have all behaved the same way over the past number of years despite various market influences. This is not a diversified portfolio. Investors should also be aware that during periods of extreme turmoil, many investments that otherwise behave independently, begin to react the same way – in that their correlations go to 1. This is especially true for publicly traded securities and a good example occurred during the 2008 debt crisis. In this situation, a significant majority of public securities in both the equity and the debt markets began to move the same direction and investors had a very difficult time finding a safe haven from the volatility.
And so this begs the question: if public equity correlations tend to go to 1 during stressful periods (and this is exactly when investors need all the risk mitigation they can get) where can real diversification be found to protect those hard-earned savings? At Capstone Private Wealth, we believe the answer to that question is in non-traditional markets. These investments are not typically traded on a public stock exchange and includes securities such as private mortgages, private equity, infrastructure projects, land or real estate development, private debt, and others. While non-traditional investments are often characterized by their unique risks and barriers of entry (such as high initial capital contributions or limited liquidity), they may be the solution to providing portfolio stability during times of market turmoil. Don’t hide your head in the sand and simply hope that the stock picks you made will avoid or weather whatever winds of uncertainty blow through the market. Do your homework, find a good portfolio manager, and be strategic, diversified, and confident that your approach can stand the test of time.
Maria Dawes, Portfolio Manager
Capstone Private Wealth