Lessons from 2010: Diversification Matters and Forecasters Don't

Each January, I take a look at the lessons taught (or retaught) by the market during the previous year. Even if you've heard some of these lessons before, their importance makes them worth repeating. Let's see what the market had to say this year.

Diversification Is as Important as Ever The past financial crisis caused the correlations of all risky assets to rise towards one, leading many in the financial media to report on the "death of diversification." 2010 showed otherwise. Below are the returns of various asset classes (represented by the passively managed funds of Dimensional Fund Advisors). As you can see, there's a large dispersion of returns between the best and worst performing asset classes.

U.S. Small-Cap Value (DFSVX) -- 30.9 percent
U.S. Small-Cap (DFSTX) - - 30.7 percent
Emerging Markets Small-Cap (DEMSX) -- 30.2 percent
U.S. Real Estate (DFREX) -- 28.7 percent
International Small-Cap (DFISX) -- 23.9 percent
Emerging Markets Value (DFEVX) -- 22.1 percent
Emerging Markets (DFEMX) -- 21.8 percent
U.S. Large-Cap Value (DFLVX) -- 20.2 percent
International Small-Cap Value (DISVX) -- 18.1 percent
International Real Estate (DFITX) -- 18.1 percent
U.S. Large (DFUSX) -- 15.0 percent
International Large-Cap Value (DFIVX) -- 10.6 percent
International Large-Cap (DFALX) -- 9.3 percent

All Crystal Balls Are Cloudy Almost without fail, each financial crisis has been predicted with amazing accuracy by some guru. But that ignores two important facts. The first is that even blind squirrels occasionally find acorns. In other words, there are tens of thousands of gurus making forecasts all the time. Given the number trying, we should expect some to randomly make accurate forecasts.

The past crisis produced Nouriel Roubini, professor of economics and international business at NYU's Stern's School of Business. He correctly forecasted the recent bear market, though it should be noted that he had been calling for one for a very long time. Is he a true guru, or did the blind squirrel get lucky? Let's hold Roubini accountable by looking at his recent forecasts.

At the bottom of the market in March 2009, Roubini was quite bearish. Those listening to this anointed guru missed the greatest rally in 70 years. And again in May 2010, Roubini warned: "Stocks are likely to continue their aggressive decline and shed another 20 percent in value as the world economy weakens...There are some parts of the global economy that are now at the risk of a double-dip recession. From here on I see things getting worse."

As much as we'd like to believe otherwise, there's only one person who can tell us where the economy and the market are going, and none of us gets to speak to him (or her), at least while we are alive.

Follow the series: Lessons from 2010
Diversification Matters and Forecasters Don't Bad News, Good Returns Bad Strategies, Good Tax Management and Staying in the Market Refreshers
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.

Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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