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Diversification Is Still Alive and Well

If you regularly read this blog, you know I'm a big fan of holding the financial media accountable for their predictions and proclamations. Since I'm now part of the financial media, I should be held to the same standards. Last year, I defended asset allocation and diversification in the wake of the market turmoil. Let's take a look at how diversification has fared since being declared dead a few years ago.

During the financial crisis of 2008, it appeared that diversification didn't work when it was needed most, as many asset classes tumbled -- stocks, commodities, junk bonds, preferred stocks, convertible bonds and emerging market bonds all got hammered during the crisis.

Does diversification no longer work? Before looking at the evidence, it's important to understand the following. During systemic crises like the global financial meltdown we experienced in 2008, the correlation of all risky assets tends to sharply increase. However, the correlation of the safest investments to risky assets tends to decrease -- as evidenced by Treasury securities producing strong positive returns in 2008.

Thus, what you must understand is that the most important diversification is to make sure your portfolio contains a sufficient amount of safe bonds and other fixed income investments to dampen the risk of the overall portfolio to an acceptable level. You must then also accept that when systemic crises arrive (such as in 1973-74 and in the aftermath of the events of September 11), the risky assets in your portfolio will likely all perform poorly. However, once the crisis has past, correlations are likely to return to the long-term relationship, and the benefits of diversifying risky assets will again become obvious.

We can see that by looking at the returns of DFA's various asset class funds for the year 2009 and the first three quarters of 2010. For 2009:

  • U.S. Large-Cap (DFUSX) -- 26.6 percent
  • U.S. Small-Cap (DFSTX) -- 36.3 percent
  • U.S. Large-Cap Value (DFLVX) -- 30.2 percent
  • U.S. Small-Cap Value (DFSVX) -- 36.3 percent
  • U.S. Real Estate (DFREX) -- 28.2 percent
  • International Large-Cap (DFALX) -- 30.6 percent
  • International Small-Cap (DFISX) -- 42.0 percent
  • International Small-Cap Value (DISVX) -- 39.5 percent
  • International Large-Cap Value (DFIVX) -- 39.5 percent
  • Emerging Markets (DFEMX) -- 71.8 percent
  • Emerging Markets Value (DFEVX) -- 92.3 percent
  • Emerging Markets Small-Cap (DEMSX) -- 99.7 percent
  • International Real Estate (DFITX) -- 37.0 percent
Clearly, there were benefits to diversification of equity risks:
  • In 2009, the dispersion of returns was from a low of 26.6 percent for U.S. large-cap stocks to a high of 99.7 percent for emerging market small-cap stocks -- a difference of more than 73 percent.
  • Even just domestically, the gap between the highest (small-cap value) and the lowest (large-cap) returning asset classes was almost 10 percent.
  • International real estate outperformed domestic real estate by about 9 percent
  • International large-cap value stocks outperformed U.S. large-cap value stocks by about 9 percent
  • International small and small value stocks outperformed their U.S. counterparts by about 6 percent.
As the list below demonstrates, this wide dispersion of returns continued in the first three quarters of 2010.
  • U.S. Large (DFUSX) -- 3.9 percent
  • U.S. Small-Cap (DFSTX) -- 11.6 percent
  • U.S. Large-Cap Value (DFLVX) -- 6.4 percent
  • U.S. Small-Cap Value (DFSVX) -- 10.2 percent
  • U.S. Real Estate (DFREX) -- 19.8 percent
  • International Large-Cap (DFALX) -- 2.1 percent
  • International Small-Cap (DFISX) -- 10.6 percent
  • International Small-Cap Value (DISVX) -- 4.9 percent
  • International Large-Cap Value (DFIVX) -- 2.9 percent
  • Emerging Markets (DFEMX) -- 12.0 percent
  • Emerging Markets Value (DFEVX) -- 12.6 percent
  • Emerging Markets Small-Cap (DEMSX) -- 21.7 percent
  • International Real Estate (DFITX) -- 11.0 percent
The evidence presented demonstrates that the investment world isn't flat and the benefits of global diversification are still present.

More on MoneyWatch:
Asset Allocation Is Not Dead The Investment World Is Not Flat Chasing Yield Is Never a Good Strategy Are Corporate Bonds a Good Investment? Why International Diversification Is Important