Are You Concentrating Your Risk? - 3 January 2012

Beware this concentration of risk, hidden in "diversification"...

ASSETS which investors often use to diversify risk in their portfolios are starting to move  closely together with stocks, notes Brian Hunt in Steve Sjuggerud's Daily Wealth.

Take copper or a broad commodity index – they are moving in the same "up and down" fashion as stocks and exhibiting similar returns. So math majors would say these assets are "highly correlated".

Another asset many financial advisors and 401(k) salesmen claim is a "portfolio diversifier" is emerging markets – meaning stocks in places like China, India, Indonesia, Brazil, and Vietnam. Our chart today shows this just isn't the case right now.


 
This chart shows the two-and-a-half-year performance chart of the benchmark S&P 500 stock index (black line) plotted alongside the performance of the big emerging markets fund, EEM (red line).

This fund is a broad basket of emerging market stocks. And as you can see, the two are moving in lockstep right now and sport the same returns. If you think you're diversifying your portfolio by investing in far-off lands, think again.

Such "super concentration" of risk comes thanks to rising correlation between the daily movements in the prices of those different assets. And this correlation bogeyman has even grabbed ahold of trees.

Owning productive timberland has traditionally been a great portfolio diversifier. Trees don't care about a "flash crash" or the Nasdaq, they just keep growing. And buying the stuff at a good price in a private deal is always a good idea. Even publicly traded timberland stocks typically provide portfolio diversification.

But as you can see from this chart, timberland stocks are also moving in lockstep with the overall market.



Our second chart above shows the two-and-a-half-year performance of the benchmark S&P 500 stock index (black line) alongside two of the largest timberland stocks, Plum Creek Timber (green line), and Potlatch (blue line).

Both Plum Creek and Potlatch own huge swaths of American timberland, and both now sport extremely similar price action to the overall market. Even timberland is moving in the "risk on, risk off" trade these days. Beware this concentration of risk, hidden in "diversification".

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