Diversification doesn\'t always insulate investors, and details matter

Date: Monday, February 2, 2009
Author: Gail MarksJarvis, Chicago Tribune

There is a sense of betrayal among investors who have been conscientious.

And when they talk about it, they sound like individuals who find themselves with a fatal disease after a lifetime of healthy living—eating a well-balanced diet, exercising and staying away from cigarettes.

"I thought I was doing everything right," a lawyer told me recently about his 401(k). "I didn't swing for the fences. I did what I was told. I diversified, and now look."

He hadn't picked a couple of hot stocks or relied on one stock mutual fund. He had assembled a combination of stock mutual funds and a bond mutual fund with the idea that if the stock market was ever brutalized, his numerous selections would buffer the impact.

Then came last year. The stock market crashed, and he lost about a third of his savings.

Now he's not sure if he can count on diversification to save him from ruin. His questions are being asked within investment circles too.

"The cry has gone up from institutional investors around the world: "What the hell went wrong with my portfolio? I thought I was diversified," noted Ben Inker, chief investment officer for GMO, a money management firm.

Diversification did work to a degree to keep losses down—it just didn't offer as much protection as investors imagined, because the market collapse was so extreme.

An individual who had adopted a classic diversified portfolio, which put 40 percent in bonds and cash, and the rest in various stock indexes, would have lost 23 percent of their money last year, noted Michele Gambera, an Ibbotson Associates economist. That sounds terrible, but it's quite a bit better than the 35-40 percent losses suffered by people 100 percent invested in stocks.

"I think people got carried away with diversification," said Brett Rentmeester, director of Altair Advisers in Chicago. They tried private-equity investments, hedge funds, commodities, real estate or real estate investment trusts, and stock funds that sliced and diced stocks into various types—those from foreign countries, those from the U.S., those that selected large companies or small companies, and those that picked the fast growers and the slower growers, or what are called "value" stocks.

In the end, they were all overvalued and went down hard. The declines were similar, defying the averages that show up in academic research on diversification.

According to mutual fund tracking firm Lipper Inc., in 2008 the average fund that selected large-company stocks dropped 37 percent, while small company stock funds lost 36 percent, real estate funds lost 40 percent, commodity funds lost 40 percent and international stock funds lost 43 percent.

The results seem contrary to recent research that showed investors can usually count on real estate and commodities to go up when stocks fall.

But it turns out that investors took the research to an extreme conclusion. While real estate and commodities tend to be a buffer when the stock market falls, that's not always true. And research by Ned Davis Research shows that when investors need protection the most, diversification can fail to deliver what they envision.

In the worst periods in the stock market—or bear markets—there is a tendency for assets of various types to decline together, said Ed Clissold, senior global analyst with Ned David Research.

The firm analyzed what's called the "correlation" of everything from U.S. stocks to emerging market stocks, commodities, bonds and the euro, and found them acting similarly, rather than differently, in bear markets. And the most extreme example was 2008, Clissold said.

Then, according to Ibbotson research, diversification helped but had limited power. The classic portfolio that lost 23 percent would have been divided like this: 30 percent in the Standard & Poor's 500 index, 10 percent in the Russell 2000 index of small-cap stocks, 20 percent in the MSCI EAFE international index, 30 percent in the Barclays Aggregate bond index and 10 percent in cash.

In the bear market that began in 2000, the results were different. Diversifying would not have saved them, but diversifying helped a lot. In 2001, the diversified portfolio declined just 4.75 percent.

Meanwhile, there were sharp winners during the 2000-02 bear market that did not exist in the last bear market, said Larry Swedroe, a money manager and author of "The Only Guide to Alternative Investments You'll Ever Need." In 2001, investors who selected small-cap value stocks had a 40 percent return.

Last year, with the credit crisis threatening every type of stock, the average small-cap value fund fell 33 percent.

So what are investors to do if they count on diversification to save them?

Diversification remains effective, but investors misapplied it, Swedroe said. They have forgotten the basics on bonds in a portfolio.

That's not the place for any risk-taking, he said. During 2008, diversified investors were punished in bond funds as well as stock funds because high-yield bonds in diversified bond funds crashed like stocks. High-yield bonds dropped 26 percent, while the average diversified bond fund lost 14 percent. Investors should expect high-yield bonds to act like stocks, Swedroe said.

So he advises investors to stay out of risky bonds and invest the bond portion of a portfolio only in U.S. Treasury bonds (preferably Treasury inflation-protected securities, known as TIPS), certificates of deposit and top-rated AAA municipal bonds.

Gail MarksJarvis is a Your Money columnist. Contact her at gmarksjarvis@tribune.com