Diversification is a hedge against uncertainty
To start, let’s discuss what diversification is and what it is not. Diversification is a hedge against uncertainty. If one knew with 100% certainty what the best performing investment would be, any rational investor would simply put all their money into that one single investment because owning anything else would detract from performance. The less certainty you have, the more diversification you should seek.
Diversification is a function of concentration and correlations
Diversification is less about increasing portfolio returns, and more about creating a smoother ride. For example, let’s say you have two investments that will generate the same return but with very different performance trends. In this scenario, you will end up with the same returns whether you own one investment, the other investment or both. But the day-to-day volatility of those returns should be dampened when you own them together vs. owning them separately. Just how much the volatility is dampened will depend on (1) the concentration of the portfolio in each investment and (2) the correlation between the investments.
The problem in portfolios today is that concentration is high…
The narrow leadership of the past decade has led to high market concentration in those areas that have worked, namely US over international, large caps over small caps, and growth over value. Whether one focuses on single stocks, sectors, regions or styles, the level of concentration in the stock market is at or near record levels (Charts 1-4).
…AND so are correlations
The very assets most sought after as sources of diversification, such as bonds and alternative investments, tend to have high or rapidly increasing correlations with stocks. Consider the Wilshire Liquid Alternatives Index, which is predominately made up of hedge funds. Both liquid alternatives and the broader hedge fund universe have become extremely correlated with stocks (Chart 5). In their limited history, cryptocurrencies have also become increasingly correlated with stocks, particularly with the areas of the market where concentration is the highest (Chart 6).