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Is There an Alternative to Diversification?

In my previous post, I discussed how the financial media is jumping to proclaim the death of asset allocation. Some of the comments I received highlight another issue facing those who advocate abandoning proper asset allocation principles: Failing to offer a more credible strategy.

For example, while the attackers knock diversification, they don't explain how concentrating assets reduces risk. Of course, concentrating assets increases risks because it increases the potential dispersion of returns. And note that if a strategy makes sense, it should make sense for investors everywhere. So, for example, how can it be right that U.S. investors should abandon international diversification (because correlations turned high in 2008) and, based on the same logic, international investors should abandon U.S. investments?

What about a superior alternative to buy, hold and rebalance? Again, the rumormongers don't offer any viable alternatives. And the reason they don't is that the evidence from studies published in peer-reviewed academic journals shows that active management does not demonstrate an ability to consistently outperform. That's why active management should be considered the triumph of hope, hype and marketing over wisdom and experience.

The evidence from studies on mutual funds, hedge funds, venture capital, pension plans and individual investors is virtually identical: In aggregate, they fail to outperform risk-adjusted benchmarks, and there's no persistence in performance beyond the randomly expected (with the exception of venture capital).

Nothing that happened in 2008 changes anything about the winning strategy. All that happened was that systemic risk showed up. The track record of economists and money managers makes clear that the appearance of such risks is unforecastable.

This is a good thing. The inability to forecast such events is what makes stocks risky and, thus, accounts for the large equity risk premium investors have earned over time -- well, at least for those that have had the discipline to buy, hold, rebalance and ignore the clarion cry of "This time its different."

The bottom line is that in a world of uncertainty, the safest port is still diversification. And it always will be. Unfortunately, as former Clipper Fund manager James Gipson noted: "Diversification for investors, like celibacy for teenagers, is a concept both easy to understand and hard to practice."