Many advisors and investors assume that holding multiple asset classes is often enough to achieve adequate diversification.This basic view of diversification can leave portfolios at risk at the worst possible times, during major corrections and bear markets. Many investors know better.
This article shows how stock and bond correlations have changed, why broad portfolios may not really be diversified, and how investors, investment advisors, portfolio managers, and allocators can audit portfolios so that diversification works for them at the most important times.
Some “Diversification” is an Investor’s Enemy
Core portfolios that appear to be diversified, or hold hundreds or more securities across multiple asset classes, can still move together, so that in down markets they may lose far more than investors expect. That lack of diversification can damage a client’s ability to meet their short and long‑term goals, and damage your reputation.
Do more holdings equal a diversified portfolio? The answer is no—it’s how those holdings behave together. A case in point is the traditional stock-bond diversification strategy, which has increasingly been viewed as insufficient by institutional allocators, though many financial advisors still rely heavily on the historic allocation strategy of 60 percent stocks and 40 percent bonds.
The simultaneous decline in stocks and bonds in 2022, the first such tandem fall in decades, reshaped institutional thinking about diversification. These dual drawdowns, once relatively rare, have become more frequent. Stock-bond correlation reached 0.72 in late March 2026 (see item 12 in the link), the highest point in nearly two years.
This change reflects the breakdown in the traditional negative stock-bond correlations that historically provided beneficial portfolio diversification. Institutional allocators have recognized that relying solely on stocks and bonds can leave portfolios vulnerable to market changes when both asset classes move together.
What Investors Say They Want vs. What They Mean
Many investors and advisors say they want uncorrelated returns, as an abstract diversification goal, but that may not be what they mean. What they often really want is maximum correlation to the stock market during the good times and uncorrelated or negative correlation during major market corrections and bear markets.
Investors are generally happy when their portfolios move closely with the stock market during strong bull runs, but they expect those same investments to resist losses—or even gain value—when markets slide.
Long-term correlation statistics can make portfolios look safer than they are. A 20-year correlation average may show that two assets move independently, but averages can hide what happens during a crisis. Correlations often shift with market conditions. During calm markets, different assets may generally move independently. When the stock market suffers large drops, however, investors often sell everything at once, and those previously independent assets can suddenly move down together.
During the 2008 financial crisis, for instance, many asset classes, including stocks, real estate, and many hedge funds, fell together. Historically, long-term correlation data had suggested these assets would cushion each other. Instead, they collapsed almost in unison.
To combat this scenario, many sophisticated institutions have moved beyond just owning different asset classes. They also diversify by how investments are managed, including dedicated allocations to tactical, rules-based strategies that can shift and adapt as markets change — rather than staying locked into positions as conditions deteriorate.
Why Tactical Diversification Matters
How can investment allocators (the professionals who decide where to put institutional money like pension funds, endowments, and foundations) and advisors seek to protect against market declines and still provide long-term growth?
Many institutions and advisors have achieved diversification by combining traditional core holdings with tactical, rules-based ETF strategies.
The key is correlation — when stock markets fall, tactical strategies can rotate into asset classes that move independently, or even in the opposite direction, to equities. Rather than staying invested with a rigid buy-and-hold strategy, these investors follow the trend. The result is a portfolio that looks to participate in growth and has a built-in mechanism to seek protection when markets turn.
Because long‑term correlations often break down in crises, diversifying by investment style and adding tactical management can help address this problem directly.
Historically, equity-focused trend-following strategies have delivered low correlations with traditional 60/40 portfolios. According to Bloomberg data through December 31, 2025, these stock-based trend strategies posted correlations of approximately 0.25–0.40 over the past year, 0.20–0.35 over five years, and 0.15–0.30 over ten years.
This low correlation makes trend-following strategies potentially valuable diversification tools. Trend-following has, in the past, shown minimal correlation with traditional assets, averaging -0.10 with global equities and 0.10 with long-term government bonds. When incorporated into traditional 60/40 stock-bond portfolios, even modest trend-following allocations (10-20 percent) have historically improved returns and reduced drawdowns.
At the same time, investment allocators have also radically changed what they care about most. Prior to 2022, many institutional allocators believed their top priority was identifying investments with higher return potential. Making more money was overwhelmingly the primary goal.
However, from the 2022 dual-market meltdown to today, the top priority among many allocators (from 49 percent to 68 percent) became diversification through uncorrelated returns. Only 29 percent of allocators still prioritized higher returns as their main goal.
This shift shows that a majority of allocators have moved from prioritizing maximum returns to protecting against potential losses through better diversification.
How to Audit Portfolios for Real Diversification
A portfolio can look well-diversified across many assets yet still carry hidden risks if one underlying factor dominates performance. Real diversification exists when no single risk factor controls most of the portfolio’s returns or volatility.
Allocators should use these macro factors to judge whether a portfolio is meaningfully diversified or just holding many versions of the same risk:
Correlation analysis
At the heart of good diversification is low correlation, where investments do not rise or fall together. Correlation analysis helps measure how much of the portfolio’s risk comes from assets moving in sync rather than from independent sources of return.
Most correlation analysis look at trailing periods of returns, such as historical 5-year or 3-year periods, but misses the next logical step. Instead of looking at correlations over time, it can be beneficial to look at correlations during specific time periods based on stock market behavior (i.e., bull and bear market periods). Allocators can then more easily spot unintended risk concentrations, detect style drift, and ensure a portfolio is not holding many iterations of the same risks.
Factor analysis
Factor analysis is a quantitative tool that helps portfolio managers and allocators see what’s really driving performance. It separates a manager’s skill, as represented by alpha, from the impact of broad market forces, as measured by beta. Macro factors reflect broad economic drivers that affect many asset classes simultaneously.
Equity market risk measures a portfolio’s vulnerability to overall stock market movements. This is a fundamental risk factor across asset classes.
Interest rate risk is particularly relevant for bond portfolios, where duration measures the percentage change in portfolio value for each one percent change in rates. Since early 2022, when the Federal Reserve raised interest rates by 525 basis points, interest rate risk has become more important to isolate from other potential return drivers.
Inflation risk reflects sensitivity to unexpected changes in price levels, which can impact both stock and bond prices when inflation runs high. The 2021-2023 inflation surge demonstrated how inflation can break traditional diversification assumptions when both equities and fixed income decline together.
According to Goldman Sachs, nearly 50 percent of hedge fund allocators planned to increase hedge fund allocations in 2026, specifically to add uncorrelated investments to their portfolios.
What Advisors Know About Diversifying Portfolios
We see a knowledge gap between many, but certainly not all, investment allocators and advisors. Many institutional allocators have developed more sophisticated diversification strategies than retail financial advisors.
Today, institutions allocate a greater percentage of assets to alternative investments, such as hedge funds, private equity, and credit, real assets, and multi-manager portfolios, compared to not quite five percent for advisors.
As of December 2025, 86 percent of institutional investors allocated to alternatives with an average allocation of 23 percent. By contrast, 26 percent of advisors allocated to alternatives, with an average allocation of only six percent.
Some advisors increasingly recognize the need for alternative investments, but the strategies they prefer are often not on their approved investment list.
BlackRock and other large asset managers note that their institutional clients now routinely use tactical allocation funds and liquid alternatives alongside traditional stocks and bonds. Individual investor portfolios managed by advisors, however, may lack these diversifying allocations.
FAQs on Correlation and Real Diversification
What other asset classes have provided low correlations to traditional portfolios?
Gold may be an effective diversification tool in unstable markets. Gold prices have historically produced low correlations to traditional 60/40 portfolios. Gold’s correlation to equities was approximately 0.10 for the one-year, 0.12 over five years, and approximately 0.15 over ten years ended December 31, 2025.
Importantly, though, gold may provide strong protection during market routs (i.e., inverse correlation) when investors sell stocks due to bad news – gold is often part of a “flight to safety” trade when panic selling comes to equity markets.
In the past, U.S. Treasuries had provided diversification for balanced portfolios of bonds and stocks. After 2022, not so much. U.S. Treasuries demonstrated correlations versus 60/40 portfolios of approximately 0.55–0.65 over the one-year period, 0.45–0.55 over five years, and 0.35–0.50 over ten years. Like gold, U.S Treasuries can be inversely correlated with equities during panic selling periods as investors move out of stocks and into so-called safe-haven assets like U.S. Treasuries.
At what investment stage do traditional stock‑and‑bond portfolios most often fail to deliver diversification when markets are volatile?
The biggest failure for investors is typically among clients who are in or near retirement, because they cannot withstand big losses during bear markets and often lack the patience to stay invested in hopes that it recovers, which can take several years in downturns.
Can a tactical strategy provide better diversification benefits during market downturns, and if so, how?
Yes. Tactical strategies aim to make money when markets rise and aim to avoid losses when they fall. Because tactical strategies can mitigate risk or shift into diversifying assets when markets weaken, they have historically behaved differently from traditional 60/40 stock‑bond portfolios during major drawdowns.
According to AQR, diversified liquid alternative portfolios, which include tactical allocation, managed‑futures, and other non‑traditional strategies, have typically exhibited correlations of roughly 0.0 to 0.4 versus a traditional 60/40 stock‑bond portfolios since 1990.
During 2022, when both stocks and bonds declined together, tactical strategies moved away from falling equity prices and avoided the duration risk of rising interest rates and bond yields.
Is there such a thing as too much diversification?
While true diversification is good, institutional allocators and retail advisors must ensure that their portfolios are not over-diversified. “Diworsification” was coined by Fidelity’s legendary portfolio manager Peter Lynch to describe what happens when adding more holdings to a portfolio makes the allocation worse, not better. Instead of reducing risk, overdiversification can dilute a portfolio’s best ideas. The more holdings you add, the more your returns may mirror the market, and in effect, a closet index fund.
Key Takeaways: How to Really Build Diversified Portfolios
Building truly diversified portfolios requires a new perspective.
- The traditional 60/40 stock/bond allocation strategy has been upended since 2022, when both stocks and bonds declined together.
- Actual diversification focuses on underlying risk drivers and factors. The number of holdings is not the only factor.
- Alternative investments may help increase diversification by providing uncorrelated total returns.
- Regular portfolio audits using tools like factor analysis and scenario testing can identify fake diversification.
- A core and non-core allocation using tactical ETFs may allow allocators and advisors to seek long-term growth and protect against short-term market declines.
Investment allocators and advisors who recognize these shifts can build portfolios designed for growth and protection over time. Click here to learn more.
About McElhenny Sheffield
McElhenny Sheffield believes that avoiding material losses is the foundation of successful long-term investing. Risk management and capital preservation are the firm’s top priorities.
The firm is committed to protecting investors’ financial futures through a rules-based, proven, momentum-driven, trend-following tactical ETF strategy, and positioned as a tactical satellite portfolio for advisors who need to protect their clients’ core portfolio while still seeking growth.
Clients include independent-thinking investment advisors across the U.S., large investment allocators, and high-net-worth individuals and families looking for a second opinion. McElhenny Sheffield also provides sub-advisory services for RIAs and financial advisors. The firm was founded in Dallas, TX, in 2000, and manages more than $760 million in assets as of March 31, 2026.
Past performance is not necessarily indicative of future results. Investing involves risk. Principal loss is possible. The information contained in this material is current as of the date of this article and reflects the views, data and market conditions at a point in time. Market conditions, portfolio holdings, and other factors may have changed since that date. MSCM undertakes no duty to update the information contained herein. There can be no assurance that tactical strategies will be implemented as designed, or profitable, or that clients will not lose money. The tactical strategies use a variety of market indicators and stop levels that seek to identify upward or downward trends in the U.S. equity markets. If an indicator or stop level fails to detect significant downturns in the market, the strategy will continue to be exposed to underlying positions that could lose value during such downward periods. Similarly, if the indicators fail to timely identify a reversal of a downward trending market, the strategies will continue to be exposed to defensive Exchange Traded Funds (ETFs) at a time when there is significant appreciation in the equity markets. Either scenario could result in the strategies underperforming other strategies that do not employ these strategies.
There can be no guarantee the tactical strategies will correctly or timely identify the industries, sectors, or asset classes that will outperform during a given quarter or that the strategies will correctly or timely identify market trends. The tactical strategies invest in other investment companies and ETFs which result in higher and duplicative expenses. Investing in ETFs are subject to risks that the market price of the shares will trade at a discount to its net asset value (NAV), an active secondary trading market will not develop or be maintained, or trading will be halted by the exchange in which they trade.
The information contained in this article has been obtained from sources believed to be reliable; however, its accuracy, completeness, and timeliness cannot be guaranteed. Any opinions or estimates reflect the author’s judgment as of the date of publication and are subject to change without notice. This material is provided for informational purposes only and should not be construed as legal, tax, or investment advice. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation.