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Are we clinging to failed strategies?

(MoneyWatch) Financial Advisor magazine highlights a report admonishing advisors who thought diversification would save their clients' portfolios from difficult markets. Unfortunately, this represents a misunderstanding of the way financial markets work.

The report, by New Jersey investment firm Risk 3.0 Asset Management, said that "advisors have not understood the impact of what can only be seen as a historic and seismic shift in global financial markets and what that means for their clients and their business." It also called out advisors for their views on diversification, saying "they still think that diversification is the answer and is going to save them, even though diversification didn't save anybody in 2008."

The root of the problem is that the report's author doesn't understand modern portfolio theory very well. Here's a quick breakdown of the four major components of MPT:

  • Markets are too efficient for active managers to consistently exploit them for profit
  • Over the long term, asset classes typically provide returns according to their levels of risk
  • Diversification can increase returns or reduce risk (In some cases, it can actually do both)
  • There's no perfect portfolio; there is only a portfolio that is suited for an investor's given level of risk and expected returns.

In this case, Risk 3.0 is centering on the diversification argument. The claim is that diversification was proven to be a sham in 2008 because all major stock asset classes fell together. Investors who counted on international stocks to hold up while domestic stocks fell saw their entire portfolio drop.

However, that's not the way this works. During times of crises, risky asset classes (such as stocks and junk bonds) often see their correlations rise to one, meaning they start moving more in lockstep. This is nothing new, nor is there anything in MPT that implies that this shouldn't happen. Correlations are only averages, and they're not static.

Whenever there are systemic crises, the correlation of risky assets has always tended to rise toward one. That doesn't mean that diversification failed. That only means that the most important diversification is to make sure your portfolio has sufficient safe fixed-income assets to dampen the risk of your overall portfolio to an acceptable level.

In fact, during the financial crisis, the correlation of the safest investments (Treasuries) and stocks went from a historical average of about zero to significantly negative. For example, from 1927 through 2007, the quarterly correlation of the S&P 500 Index and five-year Treasuries was 0.07. From 2008 through September 2012 it was -0.61. Sure looks to me like diversification was working -- assuming you did it right.

The fact that financial crises make asset classes move together doesn't mean that diversification is any less important. It means that diversification is likely to add value over the long term and that you need to plan for crises.

This doesn't mean trying to predict when such crises will happen -- no one can really do that -- but rather trying to make sure your portfolio is ready when it does happen. This happens through having the right amount of safe bonds in your portfolio. Investors who know their financial history understand that and incorporate that knowledge into their portfolio strategy. This is why one of my favorite sayings is what you don't know about investing is the investment history you don't know.

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