JonathanBurton

SAN FRANCISCO (MarketWatch) — The hard tumble that U.S. stocks took late last month was certainly a wake-up call for complacent investors who’d grown accustomed to uninterrupted monthly gains. A louder alarm, however, may be coming from a market event that didn’t happen: Not a single high-yield bond issuer defaulted in February, the first time that’s occurred in at least seven years.

High-yield bonds are supposed to be risky. But risk evidently isn’t what it used to be. True, investors have fled stock mutual funds this month for bond funds and savings accounts, but many remain convinced that stocks will steer clear of an imminent correction. That certainly makes investing more palatable, but it also upsets portfolio diversification — the balance between investment risk and reward.

As a result, investors are being exposed to an even greater danger — that their portfolios won’t be diversified enough to shield them from an unwelcome market shock.

Traditionally, diversification has meant pairing U.S. and international stocks with bonds, cash, real estate and other alternatives such as hedge funds and commodities. When the Standard & Poor’s 500 Index SPX, -0.61% peaked seven years ago this month, for example, alternatives including U.S. small-cap stocks, international stocks, hedge funds, commodities, gold, Treasury bills and high-quality bonds all brought meaningful diversification to the U.S. market benchmark.

It’s different this time. A new Merrill Lynch study shows that small-caps and international stocks, which not coincidentally have posted stellar gains in the last few years, are moving virtually in lockstep with the S&P 500, essentially eliminating their once-distinct diversification benefit. Hedge funds and real estate also are increasingly indistinguishable from the index. See related story.

How do you protect yourself today, then? Go where other investors haven’t, Merrill strategists are advising. Buy the assets that people will buy if the stock market has a protracted downturn.

Investments bringing the greatest diversification from global stocks and real estate, Merrill research shows, include these five: high-quality government and corporate bonds, cash, commodities, gold and, within the stock market, the consumer-staples sector.

Equity investors should probably look upon bonds and cash and powerful diversifying assets the same as they looked seven years ago upon hedge funds and non-U.S. stocks, Merrill analysts wrote in a March 5 report.

Proper diversification means owning a collection of investments that financial types call uncorrelated. That’s a fancy way of showing that returns aren’t closely linked. Holding investments that move independently from each other dampens a portfolio’s volatility and the emotional swings that invariably accompany it.

It’s very important to have a portfolio with assets that are not correlated to the stock market, said Kevin Ellman, a financial adviser with Wealth Preservation Solutions in Ridgewood, N.J. You’ll have a smoother ride and you’ll be compounding at a steadier rate. It’s better for long-term wealth creation. It also tends to prevent the big mistakes, where people panic and sell everything.

But in a period where inflation is benign and the global economy is strong, investments that typically pay buyers for going out on a limb are seen as a sure thing.

Double-digit stock returns make people have amnesia, said Marilyn Cohen, president of Envision Capital Management in Los Angeles, which manages bond portfolios for high-net-worth investors. Complacency has been shaken, but I don’t think it’s been shaken enough. I have met many people who have gotten immune to this kind of volatility. See related story.

Cash is not trash

Bank accounts and equivalent short-term Treasury bills are paying real money nowadays. Certificates of deposit on average yield 4.57% to lock up your cash for six months and 4.84% for a one-year commitment, according to Bankrate.com.

Treasury notes, meanwhile, are rock solid, Cohen said, as good as cash, with 30-day T-bill yields at around 5.25%. Being over 5% is really generous, she added. Be aware that short-term debt yields more than longer-term issues; 10-year Treasurys, for example, yield 4.59%, while two-year Treasurys offer 4.67%. There’s more value in the two-year area, Cohen said.

Cash and T-bills reduce overall portfolio risk and also hedge against inflation, says Peter Bernstein, financial market commentator and author of the forthcoming book, Capital Ideas Evolving.

People expect the inflation rate to remain low, he said. Premiums on risky securities have gotten smaller. But every environment has a weak link.