Diversification: A Failure of Fact or Expectation?
by Sam Stovall
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.
In this article
- Investor Misjudgments of History
- Understanding Sector Slump
- Sectors on the Upside
- Comparing Asset Classes
- Correlations & Volatility
- Annual Portfolio Returns
- Rising Volatility
- Lessons Learned
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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%).
However, investors’ expectations or memories failed. We also believe that many investors simply went too far out on the risk curve, embracing inappropriate equity exposures for their age groups, risk tolerances, or trading acumen. Hopefully, these errors in memory and expectation have been adjusted.
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