You May Not Be as Diversified as You Think

Every portfolio, no matter how well it is constructed, is vulnerable to something.

Investors who rely on actively managed funds or broad-based index funds often end up too heavy in the financial sector; those who go with individual stocks and sector funds face a similar threat if too many of their holdings correlate too closely.

One less-obvious example of this problem is with emerging-market stocks and mining stocks. Both segments have been terrific sources of outperformance for several years, and there is a compelling fundamental argument in the growth rates and increased demand to tell us that both segments should continue to do well over the long term.

As this chart of iShares S&P Global Materials Index Fund (MXI) and BLDRS Emerging Market 50 ADR Index Fund (ADRE) shows, the correlation between the two has been very tight, including during several big and fast corrections.

Click here for larger image.

The connection is quite logical. Growth and modernization in places such as China and India have been big catalysts for increased demand for natural resources. This benefits the countries that are experiencing the demand, as well as those countries capable of supplying the commodities -- many of which are emerging markets such as Brazil and Chile.

This infrastructure buildout has many more years and several hundred billion dollars to go. China needs iron ore and copper, and so will other countries such as Pakistan and Vietnam as they follow the same path, creating long-term visibility for these trends.

None of that isolates these stocks from nasty declines every now and then.

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