The Dish on Diversification

Last Updated Apr 4, 2009 7:18 PM EDT

It's long been said that the closest thing to a free
lunch in investing is diversification: By spreading your investments across a
broad mix of stocks, bonds, cash, and other assets, you can reduce the risk in
your portfolio without significantly sacrificing return. But the recent market
meltdown sent virtually every type of investment into a terrifying
synchronous slide, leaving you to wonder: Is diversification just another scam?

Looking back at the past year, it's tempting to reach
that conclusion. As you know from looking at your brokerage and 401(k)
statements, the time you spent carefully crafting the perfect mix of large
caps, small caps, emerging markets, REITs, bonds, and so on was about as useful
an exercise as those Cold War-era drills in which school kids were taught to crouch under their desks during a nuclear attack. Even professional money managers designing
supposedly low-risk diversified portfolios for near retirees failed to fully
hedge against severe stock losses.

If professional-grade asset allocation couldn't
protect you from this stock tsunami, you may be thinking, shouldn't you
just put everything in sure bets like bank CDs and three-month Treasury bills?
No, unless you're willing to retire with a lot less money and send
your kids to third-rate universities. To fight the corrosive effect of
inflation on your savings, you need to own stocks and other high-growth
investments.

Let's be honest: Diversification was oversold and its
long-understood weaknesses were conveniently overlooked during the boom years.
But as you work to dig yourself out of the mess the market has got you into,
diversification remains your best tool for taking prudent advantage of the
opportunities that the crisis has created. To paraphrase Winston
Churchill's adage about democracy: Diversification is the worst
possible system of defense against the risks of investing—except for
all of the alternatives.

Too-Great Expectations


What went wrong with
diversification was what always goes wrong with it in tough markets. Money
managers — and, yes, some financial journalists — oversold
diversification as a rock-solid bulwark against losses when all it ever has
been is a strategy to reduce, not eliminate, risk. In a bear market,
you’ll still lose money, just not as much as you would have had you
not diversified. And expecting a diversified portfolio to shield you from
short-term losses when virtually every market has taken a hit is expecting too
much.


In other words, the dirty
secret of diversification, which almost no one talked about during the boom
years, was that it works least when you need it most. “All risky
asset classes tend to go down together in a global economic
downturn,” says Rick Ferri, author of All About Asset Allocation and founder of Portfolio Solutions LLC, a Troy,
Mich., money management firm. Now they tell you.


Another problem is that you
may have had short-term hopes for what’s a long-term strategy.
Consider how a portfolio of 70 percent U.S. stocks and 30 percent long-term
U.S. government bonds fared over the 81 years through 2007. This portfolio
earned an average annual return of 9.3 percent, slightly less than the
S&P 500’s 10.4 percent gain, according to Ibbotson
Associates. But the 70/30 portfolio achieved its return with dramatically lower
volatility. The stock/bond mix lowered risk by nearly 30 percent, while giving
up only 1.1 percentage points of return. Not a bad deal.

All Together Now


Yes, you’d like to
own only winners and dodge the losers. But you don’t have impeccable
forecasting skills, nor does anyone else. So you need to own a basket of assets
that aren’t all dependent on the same set of hopes and risks. You
need to own asset classes that don’t move together so that some of
your investments will go up when others stumble. At least that’s the
theory.


While this may be cold
comfort, the across-the-board meltdown we have been experiencing is rare. Asset
classes tend to move independently for fundamental economic reasons. The
primary risk to stocks is recession. But a recession typically means lower
inflation and lower interest rates, which generally help bond prices. Likewise,
international markets, commodities, and real estate have tended to ebb and flow
at different paces.


Think back to the 2000-2002
technology implosion and market collapse. Asset allocation’s
stabilizing powers kicked in then, as you can see in the chart below. Stocks took a beating, but the losses were
offset by gains in REITs, commodities, and bonds.









Of course, it hasn’t
worked that way in 2008-09, as the chart also illustrates. The real estate and credit crises have conspired to
create a perfect storm that pushed virtually all asset classes — and
all countries — down in tandem. But even in this period of high market
stress, at least one asset class has gone against the grain: Treasuries. Last
year medium-term U.S. Treasuries surged, with iShares Barclays 7-10 Year
Treasury (IEF) generating a 17.9 percent total return. In times of great fear,
investors run for safety. Owning government bonds is a hedge against chaos.

Time to Take Stock


Even in the best of times,
what you’ll earn with a properly diversified portfolio is likely to
look middling compared to the best-performing corners of the markets. To be properly
diversified, you need to own assets that historically don’t earn as
much as stocks do. Remember, during this historic bear market, Treasury bonds
have delivered double-digit returns.


Therein lies one of the key
lessons of diversification: It doesn’t mean you can safely overdose
on stocks, as many investors undoubtedly did when the market was humming along.
Consider how much protection bonds offer: For the 10 years through this past
January, the Dow Jones Moderately Conservative Portfolio Index, a passively run
global benchmark that’s rebalanced monthly and holds 40 percent
stocks with the remainder in bonds and cash, posted a 3.9 percent annualized
total return. Over the same period, the S&P 500 lost an annual 2.7 percent.

Allocation 2.0


Another lesson of the crash
is that diversification is not a set-it-and-forget-it strategy. “What
matters isn’t just how you diversify across asset classes,”
says Adrian Cronje, director of asset allocation at Wilmington Trust.
“It’s also how you rebalance your strategic allocation
through time.” The basic rule: Favor asset classes that are paying
you to assume extra risk, while pulling back in assets that can only pay off if
everything works to perfection.


To know what you’re
being paid to assume risk, look at how the asset class is valued. Take the
dividend yield on stocks, generally defined as the past 12 months of dividends
divided by the current price. A number of academic studies have shown that you
can partially predict future stock returns by looking at measures of value such
as the price-to-dividend yield.


Check out the chart below, which shows what you would have
earned over the past 60 years if you had invested in the highest-yielding
stocks. It’s not a perfect relationship by any means, but
you’ll see that higher yields usually have led to higher returns 10
years out.



The recent dramatic increase
in yield suggests that future stock market returns are looking more enticing.
Indeed, the yield on stocks is higher than the yield on 10-year Treasury notes
for the first time since 1958.


Valuation alone
doesn’t explain everything. But it offers a valuable tool for
thinking about the relative attractiveness of different investments. At the
stock market peak of October 2007, REITs yielded just 4.2 percent, slightly
below the 10-year note’s 4.5 percent. The question was, why buy REITs
and assume the extra risk when you can earn a higher yield on risk-free
Treasuries? The answer: Lighten up on REITs and favor Treasuries. Today, yields
are suggesting the opposite. At the end of January, the REIT yield was a bit
over 9 percent, a huge premium over the 10-year Treasury’s 2.5
percent.


What should a smart investor
do?


You don’t want to
repeat the overconfidence of the past years, nor do you want to replace it with
the fear that is so rampant today. Start raising your portfolio’s
exposure to stocks, REITs, and commodities, which are attractively priced. But
remember that you don’t have perfect insight into the future, so you
have to continue to diversify. Buy into attractive sectors slowly, and
keep some cash at the ready for unexpected short-term price drops.


It’s now clear that
until the recent market plunge you weren’t adequately paid to buy
risky assets like stocks, REITs and commodities. Now you are.

James Picerno is editor of The Beta Investment Report.

  • James Picerno

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