Does Investment Diversification Still Work?

A cornerstone of Modern Portfolio Theory is the concept that you can reduce the risk of an investment portfolio by adding securities whose performance does not correlate with those in the portfolio.  Follow-on research studies confirmed that the diversification in an investment portfolio explained over 90% of the variability in portfolio returns from year to year.  This makes sense intuitively: when some asset class returns turn negative in a given year, returns from other asset classes can potentially be positive, mitigating the losses.

Then came 2008.  For the first time in history, diversification appeared not to work.  Every asset class (except for U.S. treasuries and cash) fell, some significantly.  A portfolio with a commonly recommended 60% stock/40% bond mix would have lost almost 25%.  And in 2015 the same thing occurred: all major asset classes performed poorly.  Have we reached the end of the line for asset class diversification?

John Frownfelter, Managing Director of Investment Solutions for the SEI Advisor Network, argues that diversification did indeed work in 2008 and continues to work now.  He points out that the 60/40 stock/bond portfolio loss was still the category with the fourth best performance in 2008.  Although negative, the loss was less than that of other asset allocation models.

What caused the recent diversification underperformance can be attributed in part to the economic environment in which we currently find ourselves.  With inflation so low, asset classes such as commodities whose lack of correlation with stocks traditionally provided very good diversification have struggled.  And with interest rates at historical lows, bonds have been unable to provide the level of income needed to support favourable portfolio returns during those years when stocks falter.

However, it would be a mistake to abandon diversification.  Because the only other alternative is to try to time the market by investing only in those asset classes that perform best each year.  In previous articles I’ve demonstrated why this is impossible to achieve consistently.  Frownfelter tested two approaches that are formulaic (i.e. not based on emotions or crystal-ball gazing) and compared them to a diversified methodology to see which performed better throughout this period.  Approach #1 invested the portfolio entirely in the asset class (out of the three I mentioned above) that performed best the previous year.  Approach #2 invested the portfolio in the previous year’s worst performing asset class.  Lastly, he compared both to a portfolio equally weighted each year between the three asset classes.

Which methodology worked best?  Over the fifteen years ending in 2015, not only did the equal weighted portfolio exhibit the lowest standard deviation (12%), it also generated the highest average annual return (7%).  Regarding returns, however, on a year-by-year basis, the equal-weighted portfolio’s return was lowest 80% of the time, while the best of previous portfolio’s return was highest 50% of the time.  But it’s important to keep in mind the main purpose of diversification: not (necessarily) to maximize your returns but rather to minimize the volatility to prevent you from doing something self-destructive like buying high and selling low or even dropping out of the market entirely.

Diversification remains the best way to help manage risk over time while gaining exposure to the broad capital markets.  The uncertainty as to which asset classes will top the charts in any given year still makes diversification an essential approach to investment planning.