Diversification is critical for long term portfolio health. We’ve all heard about the benefits of not putting all your eggs in one basket, but conventional wisdom needs to be updated every now and then.

An industry has been built around smooth talking salesmen advising people to diversify their portfolios into a variety of stock and bond products. These well-dressed businessmen extol the benefits of such and such value or growth stock fund. They sound sophisticated when they tell you that small caps are countercyclical to large caps, and so forth. The reality is that stocks are stocks and regardless of how you splice up and segment them into categories, they hold inherently similar correlations.

Exchange-traded funds (ETF’s) change the old notions of portfolio management. Individual investors can now add commodities (precious metals, corn, wheat, soy, cattle, oil, natural gas, etc.), currencies, and specific sectors of the economy just as easily as they can add stocks.

Currencies, in particular, offer individuals a powerful alternative for hedging inflation and the decline of the US dollar, and adding a new level of diversification to offset adverse movements in stocks and bonds.

Overall portfolio risk can be measured in the variance of returns, which is a function of the individual assets held. To decrease total system variance it is best to include assets that are negatively correlated to each other.

Someone holding predominantly US stocks in their portfolio should consider adding currencies that are negatively correlated. It turns out that Swiss Franc, Japanese Yen, and Swedish Krona move in opposite directions as US stocks, while Australian dollar, Mexican Peso, and Canadian dollar move in the same direction.

Holding Swiss Franc, Euro, Yen, or Krona would have yielded roughly between 12% and 17% in capital appreciation over the last year. Not only that, but each ETF has a dividend yield, representative of interest rates within each country.

There are multiple consderations in portfolio theory, but applying the basics can have far reaching benefits. Those concerned with dividends should hold the highest yielding ETF’s, which include British pound, Australian dollar, and Mexican peso. On the flip side, income investors should avoid Swiss Franc and Japanese Yen.

Currency ETF’s offer a great alternative to traditional methods of diversification and are great to offset further declines in our own currency. Consider that commodities price growth is largely attributable to US dollar depreciation and you can see how foreign currencies can insulate individuals from energy, food, and other commodity-driven inflation.

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This entry was posted on Tuesday, August 12th, 2008 at 6:42 pm and is filed under Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.