Diversification of investments is likely to be one of the most important tools for protecting and growing wealth in today’s turbulent economy and what could prove to be many more years of extremely challenging financial markets ahead.Because different asset classes and sectors of the global economy tend to perform well when others don’t, an investor would be wise to construct a portfolio that includes a broad mix of stocks, bonds, commodities, cash and other asset classes with the ultimate goal of growing wealth and producing income with a minimum amount of overall volatility. Even within these asset classes, further portfolio insurance can be had by holding securities which participate in different industries and operate in unique geographic regions.Importantly, diversification does not mean beating the stock market every month, but rather focuses on protecting your asset base against large swings in value by building a portfolio using different asset classes to ensure that at least a portion of the holdings are always doing well. Given the present uncertainties in the global economy, lack of clear business trends throughout the developed world and the financial market’s dependence upon the unpredictable responses of the major governments to the unfolding fiscal crisis, spreading the bets around between different markets and sectors makes more sense than ever.The most basic building block of a diversified portfolio is a palatable mix of stocks versus bonds. Looking at historic investment returns over time, the month-to-month price change in the broad categories of equities (stocks) and fixed income (bonds) is one of the most uncorrelated relationships. Over just about every meaningful time period, a basket of stocks and a basket of bonds move in opposite directions.The premise also makes sense intuitively: when times become uncertain investors crave the safety of bonds but when all looks well, investors fight for the extra return traditionally offered by jumping into stocks. In fact, an historic correlation study over the past 15 years shows that during just about every interval within this range the correlation coefficient, or statistical measure of how returns move together, is negative.While the lack of correlation between the two major assets classes is helpful, one big challenge in today’s environment is that bond yields are now sitting near their lowest levels ever. At this point in time, having a position in bonds will almost surely weigh down the portfolio’s overall total return due to the relatively low yields offered on most high quality fixed income securities. However, we must remember that preserving principal and reducing volatility is just as important as reaching for the highest return. If an investor wishes to have the funds necessary to withdraw cash for any reason or have the ability to shift into higher risk asset classes at the right time, the lower returns on bonds can simply be viewed as the cost of a portfolio insurance policy.By drilling down to the guts of the stock portion of your portfolio, often you will find that more diversification is possible. One way to diversify is to buy securities or funds that are not affected by the same variables. Clearly, media companies, pharmaceutical manufactures, retail stores and financial services companies are very different businesses. Depending on the state of the global economy, one or more of these industries should tend to outperform the others. By building a portfolio that includes securities from a number of different industry sectors, chances are that one or more would always be doing better than average.Another important dimension of diversification is geography. We live in a global world. More than ever opportunities are presenting themselves in geographic regions which only a short time ago had very fledgling or restricted capital markets. However, in recent years many of these markets have grown immensely in size and popularity. For example, although US equities still make up the largest portion of world market stock market capitalization at around 29 percent of the total, just eight years ago the US made up a whopping 45 percent! Meanwhile, China has seen its share of world market soar from less than 2 percent five years ago to about 8 percent today.The potential benefits of geographic diversification are especially important to Bermuda residents. During the ‘boom phase’ in Bermuda many local residents invested not only most of their liquid investment portfolio but also staked their career and personal real estate holdings on this one smaller market. While ‘own what you know’ made sense for certain time periods, many Bermudians have had to rethink geographic diversification as the offshore economy continues to adjust to a new paradigm.In addition to providing diversification benefits, emerging markets such as China have trumped the US and other developed markets with superior investment returns as they gain in prominence and represent stronger underlying growth rates.An academic study by Dr Burhan Yavas of California State University showed that “international diversification will result in risk reduction for a given return as long as the correlation coefficient between the domestic and the foreign market is less than 100 percent.” Dr Yavas further went on to declare that “emerging market economies are not closely correlated with industrial country markets. In fact, ongoing research confirms that investing in emerging countries offers considerable diversification benefits for international investors.”Today’s investors tend to be simultaneously intrigued and confounded by the new world of opportunities. Investing has become easier with respect to the number of possible vehicles and ease of executing trades electronically, yet all these choices can be overwhelming at the same time. Whether investing on one’s own or invoking the services of a professional, diversification should remain a cornerstone of the process helping to build wealth and income over time without creating excessive volatility and sleepless nights. Bryan Dooley, CFA is a portfolio manager at LOM Asset Management in Bermuda specialising in the areas of asset allocation, fixed income portfolio management and quantitative process. He possesses an MBA from the College of William and Mary and has held key positions with progressive financial institutions worldwide throughout a career spanning more than 20 years. Please contact him at 441-505-5675 for further information.