The Myth of Diversification


You’re probably not as diversified as you think.

  • Correlation between equity markets and interest rates has been largely positive for over thirty years
  • However, correlations typically increase across asset classes during periods of ever-more-frequent market stress, reducing the perceived benefits of diversification precisely when needed most
  • Protective investments—such as structured notes—may be an effective addition to portfolios when correlations increase, thereby reducing the benefit of traditional diversification

Since the
Greenspan Put was introduced in the late-80s, investors have come to expect the Fed to swoop in when markets get ugly. Tech Bubble, Great Financial Crisis, and, of course, Covid-19. The list goes on.
The correlation between equity markets and interest rates has been largely positive for over thirty years, resulting in the negative stock to bond relationship that is now a fixture of portfolio management and asset diversification. (Remember, when rates go down, bond prices go up.)

After the latest bout of central bank tinkering, expectations of higher rates—and inflation—are mounting.

Masters of the Universe

The Myth of Diversification

It is a well-known conundrum: during periods of market stress, correlations generally increase across most asset classes. The benefits of diversification tend to evaporate when most needed, creating one of investing’s most vexing challenges.

Interestingly, not only do asset correlations tend to increase to the downside during periods of market distress, but research demonstrates that, for a broad range of asset classes, correlations can also significantly decrease on the upside (Chua, Kritzman, and Page, 2009; Page & Panariello, 2018).

In other words: when times are good, or higher asset correlation is desirable, it reduces the return drag from diversifiers. But for a number of asset classes, correlation asymmetry can work against investors on the up and downside.

Despite the considerable attention given to diversification, these results, while not new, highlight an often naïve approach to diversification and risk management. To be clear, we are not arguing against the benefits of diversification. Rather, asset correlation and diversification are far more nuanced than most investment professionals realize. Treating correlations and the expected benefits of traditional portfolio diversification as constant is a risky oversimplification.

An Alternative to Alternatives

Alternatives are commonly thought to improve portfolio performance on a risk-adjusted basis, diversifying or mitigating many of the risk factors common to conventional stocks and bonds. However, recent research by Morningstar reveals that investors may not be getting as much diversification from alternatives as they thought.

While these strategies tend to focus on capital preservation, long-term portfolio diversification, and enhanced risk-adjusted results—areas we clearly have a bias towards—we feel investors may be overlooking an alternative to alternatives. That is, protective investments as both a financial product and an investment strategy. Protective investments—such as structured notes—are more appropriately viewed as an “alternative” solution or product wrapper, as opposed to an alternative asset class.

Today, “defined outcome”, “structured”, or “buffered” securities are a class of investments used interchangeably to describe what we call “protective investments.” These investments can combine the powerful benefits of compound growth and market upside with greater control of downside risk.

Should we continue to see the long-standing negative correlation between equities and bonds erode, investors may want to consider adding truly differentiated exposures—such as those unique to protective investments—to their investment toolkit.


Chua, D.B., M. Kritzman, and S. Page (2009). The Myth of Diversification. Journal of Portfolio Management 36 (1): 26–35.

Sébastien Page & Robert A. Panariello (2018) When Diversification Fails, Financial Analysts Journal, 74:3, 19-32.

Important Information & Qualifications

An investment in Structured Notes may not be suitable for all investors. These investments involve substantial risks. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. This material does not provide individually tailored investment advice, nor does it offer tax, regulatory, accounting or legal advice.

Hypothetical performance results have inherent limitations. There are frequently sharp differences between hypothetical and actual performance results subsequently achieved by any particular trading strategy. Hypothetical performance results do not represent actual trading and are generally designed with the benefit of hindsight. They cannot account for all factors associated with risk, including the impact of financial risk in actual trading or the ability to withstand losses or to adhere to a particular trading strategy in the face of trading losses. There are numerous other factors related to the markets in general or to the implementation of any specific trading strategy that cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. Any estimates and projections (including in tabular form) given in this communication are intended to be forward-looking statements. This should be used for informational purposes only.

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