Diversification Protects You Least When You Need it Most
The Real Diversification is Betting on Volatility
Diversification is often hailed as the holy grail of risk management. The idea is simple: by holding a mix of assets with low correlations (meaning they don’t move in lockstep) you should be safe. If one asset class tanks, others should hold steady or even rise, cushioning the blow.
But diversification doesn’t just underperform during market meltdowns, it crumbles entirely. When crisis hits, everything nosedives together.
The real safeguard? Betting on volatility itself, not scattering your eggs across a dozen baskets that all crack together.
Diversification only works in good times
Diversification behave beautifully in good times. Technology stocks might rise might while bank stocks stumble, or utility stocks might rise while technology stocks stumble.
But when panic sweeps markets, investors sell anything liquid to raise cash, driving even “uncorrelated” assets down.
Take the 2008 Global Financial Crisis. Real estate investment trusts (REITs), often touted for low equity correlation, synced up to 0.9 with the S&P 500 as credit froze. Moving 90% in the same direction.
Fast-forward to the COVID-19 crash in March 2020. Equities cratered 34% in weeks, but so did everything else. The stock-bond correlation flipped positive and even bonds sold off amid a liquidity crunch.
Why does this happen? Behavioral finance points to “flight to liquidity.” In stress, investors dump assets indiscriminately, correlations spike due to forced selling by leveraged funds and margin calls. Diversification protects you least when you need it most.
The Real Diversification is Betting on Volatility
Volatility: the one thing that’s designed to rise when markets fall. The VIX, explodes during crises—often doubling or tripling as everything crashes. Volatility strategies don’t rely on asset correlations; they thrive when everything is crashing at once.
During the 2020 crash, the VIX spiked from 15 to 85, delivering 400%+ gains for VIX-linked funds in weeks—enough to offset massive equity losses. In 2008, similar volatility bets turned a profit while the S&P 500 lost half its value.
Diversification isn’t useless, it works for everyday volatility but fails during black swan events. That’s not good enough.
Volatility investing acknowledges that crises are inevitable and prepares for them. True protection comes from what rises when everything else falls, not from hoping your carefully diversified portfolio behaves.
In investing, as in life, the best defense is one that anticipates the worst. Ditch the diversification delusion; embrace volatility. Your portfolio will thank you—especially on the days it matters most.