During the credit crisis, for many investors it became clear that traditional portfolio diversification did not provide suitable protection against risk. For one simple reason: during a highly volatile period, the correlation between different asset classes increases, thus undermining risk diversification.

This phenomenon has been studied in detail by Christopher Geczy from the Wharton School of Philadelphia, who frequently analyses and dispenses advice on portfolio diversification. Indeed Geczy confirms that during moments of crisis, the only thing to go up are correlations, especially for already correlated asset classes.

Many investors believe that simply by having footholds on both the American and international market guarantees sufficient risk protection. Although this is indeed a diversification strategy, it is not enough for riding through a crisis period, because these markets are exposed to common factors. The 2008 crisis proved how when volatility increases, the correlation between the American and international markets actually grows.

Is portfolio diversification worth it?

Despite the aforementioned problems, diversifying your portfolio is far from an erroneous practice. In fact, during crisis periods, an exclusively equity-based portfolio would generate more losses than a mixed equity – bond portfolio. In the long-term, a diversified portfolio generally achieves higher performance levels.

According to Gezcy, investors need to understand the source of risk within a portfolio and must have the ability to build one up around varied exposure to so-called “multiple risks”. By diversifying their portfolio, savers tend to believe they have also diversified their risk. But this is not necessarily the case. For example, in a portfolio consisting of 40% bonds and 60% equity, almost all the risk derives from equity.

Therefore a suitable strategy may mean building up a portfolio or leveraging investments in alternative funds, such as those proposed by Tendercapital Alternative III, which, as highlighted by Gezcy, sums up the issue of risk diversification by weighing it up according to the instruments in which the saver invests. The investor’s objective must be to have a low correlation between the asset classes they invest in. (Click on the link for more descriptive and promotion information on Tendercapital Alternative III.)

A few tips from Gezcy

At his office Gezcy also gives a few tips on which asset classes to invest in, to generate diversified risk exposure. His list includes distressed debt, infrastructures, commodities, real estate and currencies. Each category with long/short positions.

In particular, alternative asset classes provide access to sophisticated strategies and enable us to amplify diversification opportunities, so that we can benefit from low correlations with traditional investment classes.