Why Diversification Does Not Work in Today’s Market
Prechter and Kendall’s “All the Same Market” Analysis Shows how Diversification Can’t Protect You from Correlated Risk
A dear friend of mine wants to celebrate an important health milestone by going skydiving with friends. She feels happy and healthy and excited. She wants to do something very thrilling to celebrate.
I’m going to help my friend celebrate, by way of something very mundane: I intend to photograph the event from the ground. Of course I’m excited to be there, and I understand my friend’s motivation — it’s just that I am not a thrill seeker (especially when it comes to heights)!
Similarly, I don’t take big risks with my investments. I’m sure it’s a thrill to make a million, but the risk of losing all my capital is too terrifying for me to stomach.
When I started to research my investment choices, the idea of “portfolio diversification” made a lot of sense to me. All of the “experts” said it’s the key to reducing risk. It seemed safe in the same way that ropes and pulleys could really help a novice enjoy rock climbing or the trapeze.
But then I came across this gem of investing wisdom, written in terms that I understood on a visceral level:
Recommending diversification so that novices can reduce risk is like recommending that novice skydivers strap a pillow to their backsides to “reduce risk.” Wouldn’t it be more helpful to advise them to avoid skydiving until they have learned all about it? Novices should not be investing; they should be saving, which means acting to protect their principal, not to generate a return when they don’t know how. [The Elliott Wave Theorist (April 29, 1994)]
I can appreciate the metaphor. What fascinates me even more is how this contrary view of diversification is magnified when you consider how markets can correlate.
In Conquer the Crash, Robert Prechter and Pete Kendall first put forth their “All the Same Market” hypothesis, stating that in the Great Asset Mania and its bear market aftermath, all markets “move up and down more or less together as liquidity expands and contracts.”
Consider, for instance, the tried and increasingly debilitating strategy of diversification. With the market smash extending across every investment front but cash, one might think that this concept would at least be challenged by now. But it remains a virtually uncontested truism among market advisors and their followers. [The Elliott Wave Financial Forecast (Oct 31, 2008)]
The first edition of Conquer the Crash published in 2002; since then, our analysts have produced a multitude of chart-based evidence to demonstrate the coordinated trends across diverse financial markets.
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It Can be Dangerous to Diversify
Despite near-unanimous endorsement among mainstream advisors, the strategy of portfolio diversification has a huge, glaring flaw: Namely, when large sums of liquidity begin to flow into global investment markets, formerly disparate trends become strongly correlated. And markets that go up together ultimately go down together; in turn, the value of diversified portfolios goes down with them.
For years now, Wall Street has tap-danced around the liquidity risk. Here’s how former Citigroup CEO Charles Prince described it in July 2007:
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.”
Three months later, Prince announced that Citigroup’s quarterly earnings would be down 60%. Within the year, Prince had danced himself out of a job. Diversified investors around the world were feeling the liquidity crunch.
But after many miserable months for stock and commodity investors, the markets rebounded together – almost in lock-step. Commodities lifted off in late 2008, and stocks followed in March 2009. Everything that declined together was going up together, and market watchers began to take notice.
“Liquidity with respect to stocks has become indiscriminate,” reported a widely respected market technician. “When money’s flowing in, they all go up. When money’s flowing out, they all go down.”
Mainstream investors finally began to recognize the phenomenon Elliott Wave International’s Robert Prechter warned about in his 2002 best-seller,Conquer the Crash.
Turns out, now almost 10 years after Prechter coined the phenomenon “All The Same Markets,” the correlation is still positive. Unfortunately for millions of diversified investors, the outlook is not.
According to a new report authored by Prechter and his EWI colleagues, the second round of liquidity crisis is fast approaching and perhaps has already begun. If you invest your money in a diversified portfolio, it’s time you read this incredible new report now.
The common financial wisdom we hear every day in the media and through our financial advisors is that we need to diversify our investments. The reasons for doing so can be elaborated but it boils down to one thing: You diversify because you have no clue about where the economy is going!
The Case Against Diversification
Just because investment banks and stock brokerages say you should diversify doesn’t make it true.
Talk with an investment advisor, and what’s the first piece of advice you will hear? Diversify your portfolio. The case for diversification is repeated so often that it’s come to be thought of as an indisputable rule. Hardly anyone makes the case against diversifying your portfolio. But because we believe that too much liquidity has made all markets act similar to one another, we make that case. Heresy? Not at all. Just because investment banks and stock brokerages say you should diversify doesn’t make it true. After all, their analysts nearly always say that the markets look bullish and that people should buy more now. For a breath of fresh air on this subject, read what Bob Prechter thinks about diversification.
Should you or should you not diversify?
Excerpt taken from Prechter’s Perspective, originally published 2002, re-published 2004
Question: In recent years, mainstream experts have made the ideas of “buy and hold” and diversification almost synonymous with investing. What about diversification? Now it is nearly universally held that risk is reduced through acquisition of a broad-based portfolio of any imaginable investment category. Where do you stand on this idea?
Bob Prechter: Diversification for its own sake means you don’t know what you’re doing. If that is true, you might as well hold Treasury bills or a savings account. My opinion on this question is black and white, because the whole purpose of being a market speculator is to identify trends and make money with them. The proper approach is to take everything you can out of anticipated trends, using indicators that help you do that. Those times you make a mistake will be made up many times over by the successful investments you make. Some people say that is the purpose of diversification, that the winners will overcome the losers. But that stance requires the opinion that most investment vehicles ultimately go up from any entry point. That is not true, and is an opinion typically held late in a period when it has been true. So ironically, poor timing is often the thing that kills people who claim to ignore timing.
Sometimes the correct approach will lead to a diversified portfolio. There are times I have been long U.S. stocks, short bonds, short the Nikkei, and long something else. Other times, I’ve kept a very concentrated market position. My advice from mid-1984 to October 2, 1987, for instance, was to remain 100% invested in the U.S. stock market. During the bull market, I raised the stop-loss at each point along the wave structure where I could identify definite points of support. If I was wrong, investors would have been out of their positions. The potential was five times greater on the upside than the risk was on the downside, and five times greater in the stock market than any other area. Twice recently, in 1993 and 1995, I have had big positions in precious metals mining stocks when they appeared to me to be the only game in town. In 1993, it worked great, and they gained 100% in ten months. Diversification would have eliminated the profit. And every so often, an across-the-board deflation smashes all investments at once, and the person who has all his eggs in one basket, in this case cash, stays whole while everyone else gets killed.
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Excerpt from The Elliott Wave Theorist, April 29, 1994
It is repeated daily that “global diversification” is self evidently an intelligent approach to investing. In brief, goes the line, an investor should not restrict himself to domestic stocks and bonds but also buy stocks and bonds of as many other countries as possible to “spread the risk” and ensure safety. Diversification is a tactic always touted at the end of global bull markets. Without years of a bull market to provide psychological comfort, this apparently self evident truth would not even be considered. No one was making this case at the 1974 low. During the craze for collectible coins, were you helped in owning rare coins of England, Spain, Japan and Malaysia? Or were you that much more hopelessly stuck when the bear market hit?
The Elliott Wave Theorist’s position has been that successful investing requires one thing: anticipating successful investments, which requires that one must have a method of choosing them. Sometimes that means holding many investments, sometimes few. Recommending diversification so that novices can reduce risk is like recommending that novice skydivers strap a pillow to their backsides to “reduce risk.” Wouldn’t it be more helpful to advise them to avoid skydiving until they have learned all about it? Novices should not be investing; they should be saving, which means acting to protect their principal, not to generate a return when they don’t know how.
For the knowledgeable investor, diversification for its own sake merely reduces profits. Therefore, anyone championing investment diversification for the sake of safety and no other reason has no method for choosing investments, no method of forming a market opinion, and should not be in the money management business. Ironically yet necessarily given today’s conviction about diversification, the deflationary trend that will soon become monolithic will devastate nearly all financial assets except cash. If you want to diversify, buy some 6-month Treasury bills along with your 3-month ones.
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