Looks like we’ll have to rewrite most of the investment textbooks after this year.

The cherished concept of portfolio diversification has taken a big hit and may never fully recover.

Back in the day…

The conventional wisdom was that non-correlating assets would not move in tandem. If foreign stocks tanked, domestic stocks would take up the slack. Real estate and commodities would zig and zag on their own disjointed course, so as to smooth out the volatility of your other equity holdings.

So how to explain how all these asset classes moved south in lock-step this year?

Everything tanked. Foreign emerging and developed markets. Domestic large and mid-cap stocks. Value and Growth. Oil and the basket-ful of agricultural commodities. Foreign and domestic real estate…residential and commercial.

Blame it partially on the securitized mortgage securities and derivatives that found their way into global economy, so that we could export our burst housing bubble to the whole world.

But perhaps the real culprit was the hubris, the sense that the market could be tamed and parsed out on the basis of mathematical models and hypothetical theorems.

All these models were based on prior market behavior and history, but there was nothing in our history to factor in the lunacy of making loans that encouraged default over repayment.

There was never anything irrational about walking away from upside-down loans. The suspension of wisdom and prudence came from the separation of the loan origination function from the portfolio investor at the bottom of the food chain.

It made perfect sense at the time, I’m sure.

Not my problem. Not to worry.

There was, however, one diversification model that would have allowed you to survive and ride the market as it sawtooths its way back up to the next plateau.

For simplicity sake, look at these four broad areas of diversification.

1. Cash and federally insured fixed income (CDs, Treasuries, etc.)
2. Public Equity
3. Private Equity
4. Conservatively leveraged Real Estate.

Three out of four is not bad.

Cash never goes out of style. Bank deposit Dead Presidents type cash….not the faux “ultra short term high yield” junk that came down crashing and burning this past year.

Private equity could be any part-time or full-time business opportunity, partially or wholly owned, that you control. During the rough recovery ahead, the status symbol for our time will be a job you can never be laid off or fired from.

If you bought your real estate the old fashioned way, with a down payment and sufficient income to cover the mortgage, you have nothing to worry about.

If you keep these four horses pulling in harness, the strong three can carry the weak fourth until it once again finds its footing.

Posted: 11|18|08 at 5:56 am. Filed under: economics, real estate, stock market.
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