Diversification isn’t everything, but it’s a lot. And sometimes, it’s everything.
It doesn’t take much analysis to recognize that asset allocation’s value has risen sharply this year. More precisely, the right asset allocation has generally made the difference between losing a lot of money and either losing a little or even turning a profit this year. Even a passive asset allocation across the major asset classes has generated potent benefits. Indeed, the year-to-date performance numbers for the major asset classes midway in 2008 are wide ranging, as we noted last week.
That’s in sharp contrast to the horse race as it looked mid-year in 2007, when almost everything was running higher. No wonder that halfway through 2007 there was chatter that asset allocation was washed up as a strategic tool. Who needs to own everything when robust returns are falling out of trees?
So it goes in the cyclical mindset of investing analysis for the crowd, which too often succumbs to belief that the recent past informs the future. Yes, wisdom on Wall Street tends to wax and wane over time, but on these digital pages diversification’s value endures, as our update on correlations remind.
But let’s be clear: diversification is anything but static. It prevails over time, but in the short run its offerings vary, as our chart below reminds. (For easy reading, click to launch a larger view of the chart.)
Let’s start by noting that as equity markets have corrected this year, correlations between the U.S. stock market (Russell 3000) and foreign markets have trended higher. (Correlations range from 1.0, or perfect positive correlation, to -1.0, perfect negative correlation. Generally, mixing assets with less than perfect correlation improves expected risk-adjusted performance.) The same can be said of U.S. stocks and REITs. That’s par for the course in bear markets, where like-minded products tend to dive together. Of course, there are always a few surprises along the way. The fact that the correlations between REITs and equities is so high of late can be chalked up as bad luck born of the fact that bull markets in real estate and stocks seemed to have peaked together this time around.
Meantime, look at the brown, purple and blue lines in the bottom right-hand corner of the chart. Note that all have been falling for the past year or so relative to the Russell 3000. (For simplicity, all correlations in the chart are calculated relative to the Russell 3000.) Unsurprisingly, all three of these lines (representing commodities, U.S. bonds and foreign-government bonds denominated in foreign currencies) have historically provided valuable diversification benefits relative to stocks when the diversification is needed most. By the standards of the first half of this year, those benefits are once again alive and kicking.
Nonetheless, correlations fluctuate over time, sometimes dramatically. The fluctuations occasionally offer clues about what’s coming. Such was the case in 2006 and early 2007, when correlations generally were rising. But just when it seemed that diversification’s value was fading, the worth of broad ownership was only beginning to shine.
For those who stayed committed to holding a diversified portfolio across the major asset classes, the payoff has been sweet. But we have no doubt that when the bear market is over, and bull markets in equities bloom anew, diversification and asset allocation will once again fall victim to criticism and neglect. Perhaps that’s why diversification remains so valuable over time, i.e., many if not most investors ignore its benefits at critical junctures, effectively leaving large arbitrage opportunities across asset classes on the table for strategic-minded investors.
If everyone woke up to strategic diversification’s value, the benefits would undoubtedly diminish. Even so, that would inspire a fresh wave of skepticism and create new asset allocation opportunities as investors bailed out of the idea. Hope, in short, never fades for strategic-minded investors.