Diversification: A Failure of Fact or Expectation?

by Sam Stovall

Diversification: A Failure Of Fact Or Expectation? Splash image

The bear market of October 9, 2007, through March 9, 2009, witnessed not only a 57% decline in U.S. equity prices, but also the demise of many investors’ faith in the volatility-reducing effects of diversification. Fortunes were wiped away in this 17-month mega-meltdown that was triggered by the simultaneous popping of the commodity, credit, real estate and emerging equity market bubbles.

During this most recent bear market, which was the second-deepest in the past 80 years, but only the ninth longest of 15, nearly all asset classes—be they U.S. or foreign equities, real estate or commodities—exhibited the glide path of a crowbar, slumping in unison, particularly during the final six months of the bear. Today, as a result, many wonder if traditional “buy-and-hold” investing should be replaced with “run and rotate.” They also question if previously uncorrelated asset classes will now forever move in lockstep. Other investors, however, believe that during periods of financial crises, it is typical that equity-oriented or economically sensitive assets will experience positive correlations during these market downturns, only to revert to previous appreciation trajectories once the crisis has passed and they are able to relax once again.

Today, one can unemotionally sift through portfolio embers for clues to seemingly unprecedented asset class performances. We at Standard & Poor’s (S&P) conclude that diversification didn’t fail investors. Rather, allocation did do its job—a typically balanced portfolio’s (60% U.S. large-cap equities and 40% long-term government bonds) 13.1% decline in 2008 was less than the 14.8% fall seen in 1974 and much better than the results of 1931 (–22.2%) and 1937 (–19%).

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Sam Stovall , chief equity strategist of S&P Capital IQ, serves as chairman of the S&P Investment Policy Committee. He is the author of the books, "The Seven Rules of Wall Street" (McGraw-Hill, 2009) and “The Standard & Poor’s Guide to Sector Investing” (McGraw-Hill, 1995). He writes a weekly investment piece on S&P’s MarketScope Advisor platform (www.advisor.marketscope.com) focusing on market and sector history, as well as industry momentum..


John from Illinois posted over 3 years ago:

Sam, thank you for a great article which motivated me to revisit some of my calculations. I take the opportunity to share a couple of associated observations with you, and AAII Members.

UP FRONT, LET ME SAY THAT I AM A UK CITIZEN/RESIDENT, so my investment portfolio is in GBP, however, I believe that my comments are likely to be relevant to any investor, worldwide.

FIRST, your point about due to global computerised trading strategies, etc., an increase in volatility has likely become the new norm. I did some equity volatility sensitivity analysis using my 2008 (the year I retired) Monte Carlo portfolio simulation. Keeping all other inputs constant, multiplying the assumed equity standard deviation X 1.1 decreased the 90% chance portfolio life by 2 years (from 31 yrs); and X 1.2 decreased the life by 3 yrs. CONCLUSION - any new, higher volatility norm will significantly impact my portfolio.

SECOND, I looked at real declines for rolling 10-yr holding periods for a UK 50% equities, 25% bonds, and 25% short-term investments and cash portfolio (my post-retirement asset allocation). I concluded that the 18 yrs, 1964-1981, were the worst for the UK since WW2, and the average real return during that time was -2.2% p.a. (over the 9, rolling 10-yr periods within the 18 yrs). CONCLUSION - there is likely to be more UK investment pain in the next 5 to 10 yrs if post-WW2 history repeats itself.

Thanks again for a great article.

David Vornholt from Hawaii posted 7 months ago:

Very nice article, thank you. I learned several things in reading it.
I beleive the 'elephant in the room' is that investors in general have been told for many years by people like John Bogle and the financial websites is that the average investor has neither the expertise nor time to make any kind of intelligent investing decisions and therefore should only invest in three index funds (S&P500, Large international and a broad bond fund). Well, no wonder there was correlation! Everyone was investing in the same things! I stay away from large company stocks now as well as bonds. I only look at small caps with reasonable liquidity. My backtesting shows that group to have the best draw down minimization. Large caps are terrible from a risk/reward standpoint.

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