When the Dow plunged over 1,000 points this morning (8/24/2015), two things should have become clear to the casual observer:

1. No matter what stock you were in, it got pummeled. Correlations for all stocks stand at around 80%. Home Depot (HD) and Microsoft (MSFT), despite being in different industries, both dropped 3.1%.

2. International diversification didn’t help too much either. The S&P 500 (SPY) fell 3.9% while the basket of international stocks (VEU) fell 3.8%.

The problem is, correlations for stocks tend to rise during periods of stress, exactly when you need diversification to work. But instead, when you need it most, where one ideally zigs while the other zags, they both end up zagging because of the herd-like behavior of investors.

So much for diversification. When it came to common stocks, diversification failed today.

All stocks around the globe require earnings growth projections for their valuation inputs, and given how more unified economies are around the world, what affects China’s growth rates can affect us here in the U.S. We are not immune from foreign spillover effects, which is why when China devalued their currency, it signaled to the world that their economy was in trouble, and that cascaded into fears that their slowdown would eventually become our slowdown. What therefore impairs growth abroad can impair growth here, and all stocks fall.

So what you really need is something that relies on different factors for its pricing. What is this other asset that relies on different inputs and therefore behaves differently from stocks?

Investment grade bonds (symbol BND).

The prices on these assets are determined by a) interest rates b) inflation and c) credit ratings. While stock markets were taking a beating, investment grade bonds were humming along, and by the end of the day, it had closed flat, as if nothing had ever happened. This was a win for diversification.

The kicker for these is they tend to become flight-to-safety havens, so when markets undergo a lot of stress (i.e., they’re getting crushed), investment grade bonds tend to rally because of the large Treasury bond component. So when markets zig, bonds really do zag.

And that’s what we want in a diversified portfolio. Bonds are a great diversification tool, while investing in different sectors or geographies of common stocks are not as effective a tool that you’re led to believe, at least during times of stress.

(Posted 8/24/2015)

Rainier Trinidad, CFA
San Diego and Coronado’s Fiduciary Financial Advisor
Parabolic Asset Management
206 J Avenue
Coronado, CA 92118
rainier@parabolic.us
(619) 888-4070
Investment Risk Disclaimers: (i) Investments involve risk and are not guaranteed to appreciate, and (ii) Past performance is no guarantee of future results.