The diversification illusion

By Will Hubbard

Diversification feels simple—until markets test it.

When markets are steady, it’s easy to believe you’ve diversified your portfolio the right way. Stocks for growth. Bonds for stability. Maybe commodities or alternatives for inflation protection. The goal is straightforward: spread risk and smooth the ride.

And most of the time, that works.

But diversification isn’t just about owning different asset classes. It’s about owning asset classes that behave differently when it matters most—usually when markets and the broader economy are under stress.

That’s where the illusion can begin.

When everything starts moving together

Markets rarely feel dangerous when one asset class is falling. They feel dangerous when several start falling at once. That’s when investors say, “I thought I was diversified.” Or worse, they begin questioning their plan and making drastic, emotional changes.

Recently, we’ve seen periods when multiple risk-oriented asset classes moved in the same direction. The S&P 500 and NASDAQ often move together, but we’ve also seen asset classes that investors view as diversifiers—like bonds, gold, silver, and even cryptocurrency—decline alongside equities. Precious metals can act like safe havens at times, but they can also trade more like risk-oriented asset classes.

That doesn’t mean diversification is broken. It means it’s conditional.

Correlation isn’t static

Diversification depends on correlation—the statistical relationship between how two asset classes move relative to each other.

Correlation is measured on a scale from -1 to +1:

•  A correlation of +1 means two asset classes move in the same direction.

•  A correlation of 0 means there is no consistent relationship.

•  A correlation of -1 means they move in opposite directions.

If two asset classes have a low or negative correlation, they can offset each other’s moves. As their correlation approaches +1, they begin moving together, and diversification becomes less effective.

Importantly, correlation isn’t fixed. It changes based on the time frame and the market environment. A one-year lookback may tell a very different story than a 20-year lookback. During stable periods, correlations often appear low, and dispersion increases. During periods of stress, such as 2008 or the onset of the COVID-19 pandemic, cross-asset correlations spike. Portfolios that felt diversified suddenly start moving in lockstep.

The following charts show rolling correlations between three pairs of asset classes: stocks and bonds, stocks and gold, and bonds and gold. The vertical axis represents the correlation coefficient, while the lines show how that relationship has changed over time. We display both a short-term (one-month) and a longer-term (12-month) lookback to illustrate how correlations can shift with the time horizon. This is for illustrative purposes, and the same effect is evident on longer time periods as well.

Equities are represented by the S&P 500. Bonds are represented by 20+ year U.S. Treasury bonds. Gold represents gold. All data is from Flexible Plan Investments’ (FPI’s) internal database.

Short-term correlations (one-month) can swing quickly, sometimes moving from negative to strongly positive in a relatively brief period. Longer-term correlations (12-month) tend to move more gradually, but they also shift meaningfully over time. The relationship between asset classes is not constant. It evolves.

Variety isn’t independence

The illusion of diversification often comes from confusing variety with independence.

Owning a different ticker symbol doesn’t mean you own a different risk driver. A portfolio can hold domestic equities, international stocks, commodities, and digital asset classes, yet still be influenced by many of the same underlying economic or geopolitical forces.

When capital is abundant and confidence is high, asset classes tend to behave differently. When capital tightens, and investors head for the exits, they often head for the same one at the same time. In those moments, what gets sold isn’t always what’s weakest—it’s what’s available and liquid.

That’s why diversification should be evaluated across different market environments, not just long-term averages. Bull markets, sideways markets, inflationary periods, deflationary scares, and bear markets each reveal different relationships between asset classes.

The goal isn’t simply long-term diversification. It’s diversification that holds up when drawdowns occur.

Diversification is a process

True diversification means seeking independent return streams—exposures driven by different economic forces, liquidity characteristics, and structures. It also means recognizing that relationships between asset classes can change as market regimes shift. A defensive position that worked in one environment may behave differently in another.

Diversification isn’t a one-time allocation decision. It’s an ongoing process of understanding how asset classes interact and how those relationships evolve.

That’s where flexibility and adaptability become essential. Monitoring correlation, reassessing exposures, and adjusting when conditions change can help ensure diversification remains intentional—not assumed.

That doesn’t mean volatility disappears. It means risk is acknowledged and managed.

FPI’s approach to dynamic diversification

At FPI, our objective is to build portfolio solutions that recognize how risk behaves and how quickly it can change once stress enters markets and economies. We combine different return streams—such as stocks, bonds, and gold—with active strategies designed to respond to changing conditions.

Even within the same asset class, structure matters. Two equity strategies can behave very differently when quantitative methods are applied differently, creating distinct return streams from what might otherwise appear to be similar exposures.

This is essentially what active, risk-managed momentum strategies seek to achieve. Consider a portfolio of stocks, bonds, and gold. When one asset class is in an established uptrend while another is declining, a rules-based approach can shift exposure toward the stronger asset. If traditional defensive assets such as bonds are also weakening alongside equities, allocations can move toward other areas—such as gold or cash—rather than assuming historical relationships will hold.

By adjusting exposures as trends and correlations evolve, active management seeks to maintain diversification in practice—not just in theory. Strategies such as FPI’s All-Terrain are designed with this dynamic allocation framework in mind.

Diversification isn’t about owning more things. It’s about understanding what truly drives the things you own.