You May Not Be as Diversified as You Think

China is down more than 40% from its peak, far worse than emerging markets as measured by ADRE. It's also far worse than industrial metals as measured by PowerShares DB Base Metals ETF(DBB Quote).

If you think the drop in China is justified, you must also be open to the possibility that broader emerging markets and the mining/materials sector could also justifiably endure a painful correction.

If you think the decline in China is unjustified, it must also be possible for emerging markets and materials to go down a lot for no reason.

What is your total exposure to these sectors? If a meaningful decline started right now, how would that affect your portfolio? If you got caught off guard by a severe decline, would you make an emotional sale at the wrong time?

Sympathetic Sectors

The point of this article is not to debate the fundamentals of either emerging markets or materials. As the chart shows, sometimes these segments have very big moves down.

It is likely that when the next one comes, regardless of whether it is justified, it will take both of them down. Anyone getting caught with a 20% to 25% exposure between the two, which is not uncommon, is going to have to confront their emotions at that point.

The time to think about this sort of thing is now, when things are going well -- not after there has been some sort of panic.

If you are not inclined to sell down an overweight position I would suggest you mentally quantify the risk. A 25% combined exposure that rides down 20% obviously takes 5% from the overall portfolio.

Often, fast declines are followed by snapback rallies. Quantifying the risk might prevent selling at a panic low right before a snapback.

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