by Invest2Success.com
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 that not all of them will get hit at the same time or with the same degree of 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. If all your investments are doing equally well, you’re not really diversified. 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 February mini-correction and you’ll see what I mean. When the U.S. market went down, so did markets in Europe, Asia, the sub-continent, and Latin America. So did gold and silver. Oil didn’t escape the slide. Nor did blue chips, tech, and small caps. In other words, practically everything went down.

Then, everything went back up together. The China market, which started the February 27 correction, is hitting new highs. Europe and Asia have recovered, and the U.S. market is roughly back to pre-correction levels. Oil is back up. So are gold and silver, copper, nickel, corn and wheat, and cocoa.

Yes, practically everything is back up.

If everything 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 why.

Oil used to move in step with the market since 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 last year.

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 neither was gold able to escape the recent correction.

Why the heck are some of our most cherished notions of market behavior crossing us up? Because the market has transmuted in some very fundamental ways. There are four historic shifts that 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 different mix of minor markets they sell to in the developing world doesn’t have much of an impact on their stock price.

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-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 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 Wall-Mart to Lowe’s. If these stores begin milking their existing inventory 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.

February 27 could have been the “perfect storm,” a scenario in which markets everywhere crash when the economies of both China and the U.S. stall. Fortunately, it turned out to be a false alarm. That day hasn’t arrived for either country … yet. But it did give a hint of what could happen to the markets … and to your portfolio.

Both China and the U.S. suffer from too much liquidity and asset inflation. Both economies could go south. It may not happen. But by the same token, it’s not an outrageous scenario.

So what can you do about all this? Basically, two things.

Go with dividend-paying companies. It’s the only class of companies 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 per cent (compared to the 50-percent downturn in profits).

Second, go with what you know. Even if what you know is one thing (which, of course, goes in the opposite direction of diversification). The business or sector you choose may not be immune to a bad fall. But you’ll have such a good feel for the business 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 Buffet 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 as we move forward.

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