Does Diversification Still Work?

It has been said that in times of great crisis, all correlations go to one. In other words, the prices of all securities move together… perfect correlation. In the aftermath of the recent market crash it has become quite fashionable for mainstream media talking heads to claim that diversification failed us, that “there was nowhere to hide.” This is a vast oversimplification.

While it is true that with many security types, say small cap stocks and foreign stocks, there is positive correlation (asset prices generally move in the same direction), there is not perfect correlation. Some securities move up/down more than others. So there is a huge difference between positive and perfect correlation. In times of extreme risk aversion (when everyone is scared) the prices of all risky assets fall. Typically however, the prices of riskier assets fall more than the prices of less risky assets. This was true in the latest collapse. In 2008 for example, emerging market stocks fell 54% while US large caps fell 38%. Was there positive correlation in their performance? Yes. They moved in the same direction. Did US stocks fall as much as emerging markets stocks? Not even close. Clearly it was good not to have all of your money in emerging market stocks. The investor who is down 54% must earn 85% to get back to even while the investor who is down 38% must earn 61% to get back to even.

Examples of Diversification

At the highest level, owning stocks and bonds helped us tremendously in the recent decline. Stocks were down 38% while bonds were up 4%. Sector diversification helped in the recent decline. Owning utility, healthcare and technology stocks helped offset the decline in financial and homebuilder stocks. We are glad our clients did not have all their money in AIG stock… being diversified helped us. We’re glad our clients owned some growth stocks (technology) in the nineties and we are glad we owned some value stocks (financial, energy) after 2000 when technology collapsed. Small cap suffered from 1996-99 but served us well in 2000-05.

So we will continue to diversify among the major asset classes including stocks, bonds, cash and real estate.

We will further diversify as follows:

• Within Stocks: Large, Mid, Small, Foreign
• Within Equity Style: Value and Growth
• Within Stock Sectors: Ten Industry Sectors
• Within Foreign: Developed and Emerging Markets
• Within Bonds: Treasury, Agency, Inflation Protected, Muni, Corporate, High Yield, Foreign, Short, Intermediate

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.