Does Diversification Still Work?

Does Diversification Still Work?

A cornerstone of Modern Portfolio Theory is the concept that you can reduce the risk (variation) of an investment portfolio by adding securities whose performance does not correlate with those in the portfolio. This led to the identification of asset classes – groupings of securities that perform similarly under certain economic conditions – and ultimately to the idea that asset class allocation is an effective way to create and manage portfolios.  Follow-on research studies by Ibbotsen and by Beebower, Brinson, and Hood in the 1980s confirmed that the asset allocation in an investment portfolio explained over 90% of the variation in portfolio returns, significantly more than did individual security selection or market timing.  And although the research did not directly address returns, it was observed that over time portfolios comprising a balanced mix of different asset classes not only demonstrated lower volatility but in many cases higher returns as well.  This can be understood intuitively: when some asset class returns turn negative in a given year, returns from other uncorrelated asset classes can potentially be positive, mitigating the losses.

Then came 2008. For the first time in the history of the U.S. investment marketplace, 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%.  (In 1932, the worst year historically for U.S. stocks, diversification worked much better since other asset classes such as bonds performed fairly well).  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 more equity-concentrated portfolios.  In other words, diversification did its job.

What has 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 over this protracted low-inflation period.  And with interest rates at historical lows, bonds have been unable to provide the level of income needed to support favorable 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 tests two approaches that are formulaic (i.e. not based on emotions or crystal-ball gazing) and compares them to a diversified methodology to see which perform better over time.  Approach #1 invests the portfolio entirely in the asset class (out of the three I mentioned above) that performed best the previous year.  Approach #2 invests the portfolio in the previous year’s worst performing asset class.  Lastly, he compares both to a portfolio equally weighted each year between the three asset classes.

Which worked best? Over the fifteen years ending in 2015, here are the results:

Approach                                             Average Annual Return                 Standard Deviation

Best of previous year                                      5%                                                       21%

Worst of previous year                                   2%                                                        29%

Equal weighted                                                7%                                                       12%

As you can see, the diversified portfolio not only exhibited significantly reduced volatility (as measured by standard deviation), but additionally generated better returns. One interesting side-effect, however, was that the best and worst strategies did provide better results on a calendar year basis.  That is, over the period analyzed, Frownfelter found that half the time the previously best performing asset class outperformed the other two in the following year, while the previously worst performing asset class beat the others 30% of the time.  The equal-weighted portfolio only outperformed 20% of the time on a yearly basis.  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 keep 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 investment markets. The uncertainty as to which asset classes will top the charts in any given year still makes diversification an essential tool in investment planning.

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