NEW YORK (TheStreet) — With markets swinging wildly in recent years, many investors have come to fear that the old rules about diversification no longer apply. According to the traditional approach, it paid to diversify by holding a wide range of assets, including foreign stocks, corporate bonds and real estate. The idea was that when the S&P 500 fell, other assets might prove resilient and cushion losses. But in 2008, nearly everything dropped at once.

Since then stocks have rebounded, but many asset classes have provided little diversification. Last year assets such as foreign stocks and U.S. small caps rose and fell in lockstep. Even gold and oil, which once provided strong diversification, generally tracked the S&P 500. “In 2011, we saw extreme correlations,” says Stuart Rosenthal, CEO of Factor Advisors.

Rosenthal attributes the market action to what has been called “Risk on, risk off” trading. When the economic news looks positive, millions of investors around the world become optimistic and buy risky assets, such as stocks and high-yield corporate bonds. When the news shifts, investors turn sour and sell, dumping stocks of all kinds. Rosenthal says the erratic trading is likely to continue this year as investors fret about the debt crisis in Europe and sluggish growth in the U.S.

…