Heard about diversification?
It is something commonly preached as a way to reduce risk in portfolio strategies.
By investing in different types of assets, asset classes, geographies, sectors, capitalization sizes, and other subcomponent factors, the case is made that diversification will minimize risk.
This tends to be true, but given the change in global markets, it's important to reconsider diversification and how to best reduce volatility. And in a world where Knight Capital Groupproblems can skew market returns on the short term, you better have a plan to protect your assets.
The market is more connected than it has ever been before. Financial markets and monetary agencies take cues from each other as they adjust policy and make decisions. It is called "consultation” but more likely it is coordination. This is a positive as a way to reduce financial uncertainty among continents but it also means that assets now move in a more closely aligned way than ever before.
With the spread of technology, news headlines from financial services are immediately broadcast and consumed by investors around the world. How long did it take the world to hear that Steve Jobs had died? Not long and immediately markets around the world saw trading demand based on the news.
Because markets are more or less open 24 hours a day (pre-markets, open markets, after-markets), action can be taken by investors on a global basis when news is released. One only needs to examine the aftermarket price movements of positions when a company reports earnings after the closing bell. Immediately the stock reacts even though the market is already closed. In other words, the market is essentially never closed, so at any given time investors may act and react quickly without thought and based on emotion.
This democratization of information creates a slightly more level playing field, but it also means that a greater number of people are reacting to news which tends to increase volatility, and it also tends to increase correlation between assets and markets. We have seen this phenomena continue to expand as central banks attempt to overcome the downturn of 2008.
Correlation is defined as the price movement of assets and how closely they track each other. Because correlation has increased, it is more difficult to reduce risk in portfolio strategies than it used to be. Many years ago, one could simply buy international assets and U.S. assets and know that a non-correlation portfolio strategy was likely constructed. But given that the financial markets are so closely intertwined in today's world, one can no longer make that assumption.
The bottom line is that market risk has increased, and therefore risk has increased when utilizing traditional portfolio management strategies. This risk is something that is important for investors to be aware of though few recognize that the world has changed and that increased volatility levels are likely here to stay.
So what does this mean for portfolio strategies? How can you adjust your strategy to have a more stable plan for investment?
- Focus on constructing portfolio strategies that have the optimal mix of risk and return given your particular comfort level and financial goals.
- Factor in your understanding of a more closely correlated world into investment decisions.
- Increase the dividend component of your portfolio strategy as these assets tend to provide a return stream that helps reduce volatility.
- Buy risk assets in smaller increments so as to reduce individual asset risk.
- Assume bad news can play out; don't be overly optimistic EVER.
The past is a guide but not a rule. As correlation has increased among asset classes, consider adjusting how you invest your portfolio by adding a focus on risk protection The consequences of this perspective are that the returns may be muted if markets go straight up but this might be acceptable if you have constructed a strategy that helps mitigate risk.
There is more opportunity for catastrophic loss in today's market and economy than ever before. Avoiding major downdrafts should be a goal of portfolio strategy; you need to survive volatility if you want to win in this new world of unprecedented fluctuation.
Mr. Yoshikami will be a guest on CNBC's "Closing Bell" today at 4pm/et.
Michael Yoshikami, Ph.D., CFP®, is CEO, Founder and Chairman of the DWM Investment Committee at Destination Wealth Management. Michael is a CNBC Contributor and appears regularly on the network. DWM is a San Francisco Bay Area-based independent money management firm that provides fee-based wealth management services to institutions and individuals around the world. Michael was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009, 2010 and 2011.