My coworker and I were talking this morning.  Laughingly, he said, there’s no such thing as diversification anymore.  What he meant was that it appears that markets are moving in tandem, and so the benefit of diversification appears lost.    He said it laughingly because he knew that both of our convictions are the same and that we were both already thinking about how to address this kind of statement when it comes up.  This is the extent of our predictions at MAMC.

A few times today, I heard through coworkers or through an article somewhere on the web, that investors are concerned about being invested internationally.  That’s understandable.  The Eurozone economy is facing sovereign debt problems and as Thomas Friedman says, the world is flat - or in other words, globalization has taken root and world economies are more and more intertwined.

Today, the S&P 500 closed almost 4% down.  In other countries, some markets fared even worse. What is the benefit of diversification?  Where would your portfolio be if you were invested 100% in Greek government bonds?  Would you have been slightly better off if you added in sovereign debt from other European nations?  Probably, yes.  Would you have been even better off still if you added in other international securities from around the world?  Again, most likely, yes.  Why?  Because some parts of your portfolio would not have suffered the same magnitude of losses earned in the Greek government debt securities.

It is not historically normal for global markets to move in tandem.  Though losses may be abundant across asset classes, the magnitude of each market’s move is not the same - thus diversification is still completely valid.  To concentrate assets in one asset class is very risky, just as it is to concentrate in one stock.  What if your concentrated position goes the route of AIG or Greece?  How can you minimize the risk and ultimate damage that such a position would have on your portfolio?  The answer is simply to own securities around the world and to control exposure to the more risky asset classes.

How you allocate assets in a portfolio is important, but diversification, patience and discipline are critical.  If your foundation is strong, then the unknown events of the future will be easier managed.

At last year’s conference, Eduardo Repetto, Chief Investment Officer and Head of Research at DFA, presented on cross-sectional dispersion and the decay of volatility. By virtue of the topic name alone, many were left with blank stares upon their faces. Nonetheless, his presentation proved one of the most insightful. This time around, Eduardo, investigated how volatility has fared under present market conditions.

The foundation from which we work is that volatility decays slowly, and high volatility is more correlated to negative returns. Moreover, volatility is also what provides exceptional positive returns. With that said, what is today’s volatility?

There are many measures of volatility. A common metric is the Chicago Board Options Exchange Volatility Index (VIX). This measures the implied volatility of S&P 500 index options. The average VIX from 1/1990 to 7/2009, is about 20%. In the second half of 2008 through the beginning of 2009, the VIX reached as high as 80%. As of 9/28, the VIX was around 24%.

On 9/30/09, we saw the S&P 500 drop over 1%, only to rebound to breakeven by the end of lunch. The other day, we saw the S&P 500 gain 2%. Volatility is still with us, and it is still high, but it is remarkably lower than one year ago. This is not intended to derive some prediction about future volatility; rather, it is intended to show the nature of capital markets.

Managing risk must be a major component of every good investment advisor’s value added. Successful investing involves capturing the natural volatility of capital markets and removing the unsystematic risk of individual companies.