Last Updated Jul 14, 2009 12:36 PM EDT
In 2008, most asset classes produced significant negative returns. These negative returns and the significant volatility of 2008 led some to question why they should even bother with diversification.
It's odd that the theory of finance is one of the few areas where fundamental theories get questioned when there's a disaster or a crisis. We don't question the basic theories of aerospace engineering when there's an airplane crash. We do look for what went wrong and how we could prevent future airplane crashes. We should do the same with financial crashes as well -- look for what went wrong and how to prevent future occurrences. However, we shouldn't start questioning the basic theories of how to construct portfolios.
Diversification works in the long run, despite rising correlations during extreme financial crises. From 1970 through 2007, a portfolio of 60 percent S&P 500 Index and 40 percent MSCI EAFE returned 11.3 percent per year with an annualized standard deviation of 13.75 percent. For the same time period, the S&P 500 returned 11.1 percent per year with an annualized standard deviation of 15.07 percent.
Even when you throw a devastating and volatile year like 2008 in the mix, the benefits are still apparent. From 1970 through June 2009, the diversified portfolio had higher returns with less volatility than the S&P 500 alone. The diversified portfolio returned 9.6 percent per year with an annualized standard deviation of 14.6 percent, while the S&P 500 returned 9.4 percent per year with an annualized standard deviation of 15.6 percent.
The conclusion from this data is not that diversification didn't work in 2008 and that it "came back" in 2009. The conclusion is that even though diversification is not a panacea for financial crises, it's the winning strategy for the long run.