The New Way to Diversify

In its "Beginners' Guide to Asset Allocation, Diversification, and Rebalancing," the SEC writes: "Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns."

The keyword there is "historically," because recently, correlations between different investments have been growing. And this trend calls for new thinking when it comes to diversification.

Growing correlation
Among many different slices of financial markets, correlations have grown: regions, sectors, currencies, commodities, and interest rates, to name a few. According to a J.P. Morgan report, over the past 20 years the average correlation between 45 developed-market and emerging-market benchmarks has nearly doubled. Here's a summary of other increasing correlations:

Source: Re-created from J.P. Morgan, "Rise of Cross-Asset Correlations," May 2011.

All this means is that when one type of asset falls, it's more likely a different one will fall as well. That is, if you invested in commodities thinking that they would diversify and protect you from equities, that hedge would be less likely to work, now that that relationship has a positive correlation instead of the negative correlation that it once had. The closer a correlation is to 1, the closer the two items move together. As one example, Apple (AAPL 0.38%) had a high correlation of 0.72 with the S&P 500 back in 2012, but it since has fallen to a correlation of 0.37 as the market continued gaining while Apple's share price has fallen.

But why are things more correlated?

Growing intricacies
The report mentions that "high levels of correlation usually point to a common source of risk for asset prices." With globalization and the world's markets tied together tighter, the U.S. has to worry about the European Union's prospects, a Chinese slowdown puts fear into Australian miners, and Mideast oil shocks can affect energy prices worldwide, as just a few examples. But there are other reasons correlations have increased.

The report states, "Over the past few years, many investors started increasing commodity allocation" because of "their low historical correlation to other risky assets and resistance to inflation." In addition, "Risk hedging with liquid derivative products can also have an impact on correlations." And, "A decrease of asset-specific alpha increases the level of cross-asset correlations."

What all that means is that as investors become more sophisticated and efficient at hedging risks and seeking whatever returns still exist in the market, the more tied together the movements of the hedged products become.

Ben Inker of GMO writes even more on how hedge funds can drive increased correlation between previously unrelated assets: "If an event happens that costs hedge funds money in one of their other activities, they will likely respond by liquidating their positions in unrelated markets. ... [T]he hedge fund managers have taken a strategy that was historically uncorrelated with the rest of what they did and created a correlation out of thin air."

If what he have traditionally looked upon as diversified is becoming more correlated, what can we do?

A new method of diversification
Before diving into a new strategy, take note that the historical methods of diversification still can be effective. Although correlations have grown, investors can still take advantage of diversifying across sectors. If you're invested in 3D Systems (DDD 4.90%) or Stratasys (SSYS 2.19%), which share a 0.95 correlation over the past year, and you're worried that your portfolio depends too much on the future of 3-D printing, you can diversify with something like the Utilities Sector SPDR ETF (XLU 4.06%), which has a correlation of only about 0.17 with both companies. While it's not negative correlation, these two industries don't move in step together, and such traditional diversification can help.

With that, however, you also want to depend on a company's underlying strength and value more than ever. While hedging funds and investors can drive up prices beyond reasonable values, if you focus on sticking with companies that have Benjamin Graham's "margin of safety," it's less likely you'll be burned by any correlated selling.

So instead of allocating based on market capitalization, sector, and region, look to allocate based on how rock-solid you think a company's current and future financials are. The things to look for include a healthy free cash flow, low debt relative to its industry, wide profit margins, and a peek at the Graham number to get a sense of a company's valuation relative to its price.

Put it in practice
Avoiding the market's correlations will help you from getting bitten by the new efficient market structures and globalized worry. To do this, make sure you diversify not only across regions, sectors, and asset classes, but across value and company strength as well.