When the Oldest Rule in the Book Stops Working

” Wide diversification is only required when investors do not understand what they are doing.”  – Warren Buffett

Diversifying your investments is like boarding up your windows against an approaching hurricane. It gives you some measure of protection, but isn’t going to prevent the roof from falling in.

Diversification is one of the fundamental and unquestioned rules of investing. It’s supposed to protect you from huge losses. But what if it doesn’t? You could be facing potential disaster. Could conventional wisdom be so wrong? And if it is, what can you do about it?

The idea behind diversification is intuitively compelling. If you spread your investments around, chances are not all of them will get hit at the same time or with the same severity.

But it’s not a bulletproof vest. You don’t necessarily get off injury-free. And the flip side is that when the markets are going strong, your gains are somewhat curbed. But giving up some upside is well worth the price of not losing your shirt in a free-falling market.

Or so the theory goes. The only problem is, it doesn’t work anymore. Or at least you can’t count on it working.

Just look at the sharp January 22 correction and you’ll see what I mean. When the U.S. market slipped the week before that, so did markets in Europe, Asia, the sub-continent, and Latin America. And the slide continued the following Monday, when the U.S. markets were off because of the Martin Luther King holiday. For a few days, even gold and silver fell. Oil didn’t escape. Nor did blue chips, tech, and small caps. In other words, practically everything went down.

Then, after the Fed cut the benchmark interest rate 75 basis points to 3.5 percent, everything went back up. The China market ticked up. Europe and Asia made up some lost ground, and the U.S. market rebounded. Oil stayed down, but gold and silver, copper, nickel, corn and wheat, and cocoa all rose.

Yes, practically everything went back up.

The China market has since wandered down a bit, but you get the idea. If everything pretty much goes down and up together, what’s the use of diversifying? Good question.

It seems that many of the correlations (corresponding and inverse) we’ve relied on for so long are deserting us. If you’re sensing that the markets are getting more and more unpredictable, that’s probably a big part of the reason.

Oil used to move in step with the market. (Because a thriving economy stimulates oil demand and allows the market to grow.) But oil prices declined as the Dow was reaching new highs over the second half of 2006, and went up last year as the economy showed signs of slowing down.

And gold is supposed to strengthen as the market goes (or threatens to go) into decline and vice versa. But the long-running bull beginning in 2002 saw gold go up. And, for a few days anyway, gold was unable to escape the recent downturn.

Why the heck are some of our most cherished notions of market behavior crossing us? Because the market has transmuted in some very fundamental ways. Four historic shifts have altered how the market behaves. As a smart investor, you need to know what they are.

1. The global reach of multinationals. Recent studies have shown that multinationals from different countries are becoming more and more correlated. It makes sense, doesn’t it? They’re in the same major markets, and the mix of minor markets they sell to in the developing world doesn’t have much of an impact on their stock prices.

2. The world is drowning in money. Global liquidity knows no national boundaries in either its origins or destinations. It comes from China ‘s enormous one-trillion-plus dollar reserves, the carry trade (from Japan, Switzerland, and elsewhere), petro-dollar countries, and cheap credit from both east and west. And it ends up wherever there’s a quick (as opposed to safe) buck to be made.

Now I’m not saying that China invests the same way as Saudi Arabia. But all that money looking for a place to land has caused asset inflation in many markets and submarkets around the world. As these markets rise, investment flows into them at a sometimes furious pace because much of the money is leveraged. And at the first sign of the bubble bursting, the hot money leaves just as quickly.

3. Risk modeling reinforces herd behavior. Technology has made such synchronous investment behavior possible. As a common tool of institutional investors worldwide, computer trading based on risk models directs the flow of a great deal of money.

The problem is, the trend is toward more aggressive (and riskier) models, since they get the better returns… at least in the short term. It’s not so bad that funds are getting into rising markets at the blink of an eye. What worries me is that they’re getting so adept at fleeing markets first and asking questions later.

It’s a worldwide meltdown waiting to happen, feeding on its own out-of-control momentum rather than reason (even besotted reason). That makes me very nervous.

4. U.S. and China rule. In the political and military realms, the U.S. dominates. But as far as investment goes, it’s a bipolar world. Despite its huge economy and robust consumerism, the U.S. has to share the stage with China – with its huge appetite for energy, technology, and raw materials.

These two markets exert so much influence over individual companies as well as major country markets worldwide, it begs the question: Can we avoid a bear market if either of these two economies seriously stumbles?

I don’t believe so. Let’s imagine for a second that the U.S. can’t control inflation at the same time as the economy encounters serious headwinds. Where can we invest? How about Australia ? Their economy is commodity-driven and they don’t rely that much on the U.S. to buy their exports. But they do feed China a big chunk of raw materials.

Safe bet, yes? Not exactly. China fills the shelves of American stores from Wal-Mart to Lowe’s. If these stores begin milking their existing inventories and stop buying from China, China ‘s economy would downshift from fifth gear to second virtually overnight. And Australia would have just lost its main customer.

The period culminating in the sharp January 22 downturn could have been the “perfect storm,” a scenario in which markets everywhere crashed when the economies of China and the U.S. encountered big problems at the same time. It turned out to be a false alarm, but only because the Fed cut interest rates that day.

The real day of reckoning still lies ahead of us. But we did get a hint of what could happen to the markets… and to your portfolio.

China and the U.S. are supposedly dealing with opposite problems: China ‘s economy is growing too fast, and the U.S. economy is growing too slowly. I don’t buy that view. When you look a little deeper, you see that both are suffering from too much liquidity and asset inflation.

So what can you do about all this? A few things.

* Convert your holdings to cash.

You could take your money out of your IRA or 401(k) and put it into your savings account or a CD, but why subject yourself to the stiff tax penalties? Instead, look for money-market options or mutual funds that invest in short-term (1-2 year) Treasuries. If you’re having trouble finding them, call up your IRA or 401(k) administrator and ask, “Do you have money-market accounts?” “Do you have 1-2 year Treasury investments?” Any decent 401(k) plan should give you a choice of several such cash offerings.

* Invest in funds that invest in dividend-paying companies.

Companies that pay dividends are the only ones that can withstand a sudden or serious market downfall and still fork over the cash. Since 1965, the cash payout of the S&P 500 has never fallen significantly. And in the brutal crash of 2001-2, dividends dropped just six percent (compared to the 50 percent downturn in profits).

Don’t confuse “income” or “dividend” funds with funds that invest in dividend-paying companies. Income and dividends can come from bonds and other debt instruments too. Most of the funds I’m talking about come with even more specific mandates – like investing in blue-chip dividend-paying companies.

Most likely, your 401(k) or IRA will give you a choice of dividend company funds to choose from. In general, they’re all safe. It’s a matter of personal preference. But keep in mind that overseas dividend-paying companies could be a little more volatile than domestic ones.

* Go with what you know.

Even if what you know is one thing (which, of course, is the opposite of diversification). The business or sector you choose to specialize in may not be immune to a bad fall. But you’ll have such a good feel for it that you should be able to see any downturn a mile away and get out in plenty of time.

In such circumstances, there’s no shame in holding your investments in cash until the nastiness blows over. That’s pretty much how legendary billionaire Warren Buffett invests, and it’s made him more than $52 billion.

It’s better than employing a diversification strategy that’s showing signs of becoming less and less reliable.

[Ed. Note: ETR’s Investment Director, Andrew Gordon, is the editor of INCOME, a monthly financial advisory service that uncovers income-generating stocks that promise safety (first and foremost), along with much-higher-than-average profit potential.]