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Why Diversification Doesn’t Always Mitigate Risk

NEW YORK (TheStreet) -- These days, it's clear that balancing a portfolio's exposure to different asset classes provides the potential for winning investments across various market conditions.

However, I say it's delusional to think a colorful, balanced asset-class-based pie chart equates to sensible level of risk assumption. No matter how many asset classes are represented, your portfolio may still be riskier than you think.

Is this heresy? No, it's an evolution in thinking since Harry Markowitz demonstrated the power of diversification in the early 1950s and it represents a more sophisticated approach to investing.

Asset Classes

Asset classes -- stocks, bonds, and what have you -- are simply legal definitions and nothing more. The classic example of the failure of asset class diversification is the Lehman Brother's employee who held a mix of stocks, options and bonds -- all in one company that failed spectacularly.

Even modern investors can inadvertently fall into this trap. Imagine the Google (GOOGL) employee with valuable stock and options in the owner of the world's largest search engine. Let's say that person has diversified into stock, bond and index funds choosing, for example, Davis New York Venture Fund (NYVTX), Vanguard Intermediate-term Corporate Bond Fund (VCIT) and Vanguard 500 Index Fund (VFINX).

Davis holds positions in both Google Class A (7.85% net assets) as well as a stake Google Class C Stocks. Vanguard's Intermediate Corporate Bond Fund and its 500 Index fund also hold stakes in Google. However, this is only isolating one type of risk.

Risk Types

You achieve effective diversification by diversifying across the four major sources of underlying sources of risk: (1) company risk, (2) interest rate risk, (3) purchasing power risk and (4) manager skill risk. Allocating to risks, as opposed to asset classes, is how many institutional investors chose to build their portfolios.

Each risk exerts itself differently depending on the economic environment. Losses associated with one risk can be offset with gains associated with another. For instance, in the hypothetical Google example, company risk can be mitigated through buying equities and/or corporate bonds to dilute the Google share of the portfolio; interest rate risk can be eased buying the sovereign bonds of the US or other developed countries.

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