Does Diversification Work?

One of the most common refrains in the financial media and among investors is that the idea and practice of diversification failed in the crash of 2008 and has been proven to be, at best, a theoretical idealization.

In July 2009, the Wall Street Journal published an article called Failure of a Failsafe Strategy Sends Investors Scrambling in which the author laid out the arguments that would suggest that diversification had not worked for investors. Shortly after, I wrote an article in Financial Planning magazine that attempted to counter this thinking.

Dr. Ken French of Dartmouth presents his thinking on this issue here.

My analysis mirrors the perspective provided by Dr. French. He expresses the problem in terms of the difference between market risk and non-market risk. If you have a portfolio with many individual securities in it, you have reduced the risk of loss posed by any individual stock but you are probably still highly exposed to market risk. A well-diversified portfolio of stocks may have a high level of market risk or a low level of market risk. The amount of market risk in a portfolio is measurable and quantifiable.

I set up the argument somewhat differently in my article. I think about diversification as providing a way to get more return, on average, for a portfolio at a specific level of risk. There is remarkable consensus between a range of experts that a well-diversified portfolio can provide as much as 2% in additional return per year relative to a simple mix of a stock index fund and a bond index fund. Over the course of an investor’s life, an additional return of 2% per year is enormously important. In a year when the stock market drops 30% or more, an extra 1%-2% is not even noticeable, much less a consolation.

In my article in Financial Planning, I go even further to suggest that many investors do not understand the distinction between diversification and risk management. The goal of building a well-diversified portfolio is to garner the extra 1%-2% per year. Risk management is the process of controlling a portfolio’s potential loss. Articles such as the one cited above from WSJ do not make this distinction.

There are diversified portfolios that are high risk and diversified portfolios that are low risk. The investors who suffered enormous losses during the the downturn were those with risky portfolios and diversification cannot protect against such losses.

So what does a diversified portfolio look like? A portfolio is diversified if it contains assets that don’t all move in the same direction at the same time. In this way, some portion of the volatility in one asset is offset by others. In technical terms, the goal of building a diversified portfolio is to identify assets with low correlations to one another. The lower the correlation, the more diversification benefit you get. Well before the crash, the correlations showed that international stocks provided fairly little diversification benefit when combined with U.S. stocks. To fully exploit diversification benefits, a portfolio needs to contain assets other than just stocks and bonds. Examples of additional asset classes that provide benefits are commodities and real estate.

Risk management is the process of estimating the risk level in a portfolio. At the simplest level, portfolio risk is determined by the proportion of a portfolio allocated to stocks vs. bonds. More bonds tend to correspond to lower risk. Using the proportion of bonds as a proxy for risk is too simplistic for most strategies, however, because different types of stocks can have very different risk levels.  Emerging market stocks, for example, have much higher risk levels than the S&P 500.  The same is true for technology stocks and small cap stocks.  Among bonds, the same effect is present.  Corporate bonds, in particular, can have risk levels that are much higher than even the riskiest government bonds.

Many investors have no idea how risky their portfolios are.  In the face of unexpected levels of loss in 2008, it may be tempting to ascribe losses to a failure of financial theory.  This perspective will not help these  investors to build portfolios that will withstand the next financial storm.

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About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for an energy trading firm. In 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002. Geoff has published commentary and analysis in a range of publications. Quantext is a strategic adviser to Folio Investing. Neither Quantext nor Geoff Considine is an investment advisor and nothing in any content provided by Geoff Considine shall be construed as advice.

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