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the limits of diversification

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Diversified portfolios have held up remarkably well since April 2000, a period many commentators are calling the worst in 30 years. Fortunately, our particular portfolio tilt has come into its own. Our refusal to overweight tech or large domestic stocks, coupled with a strong tilt toward value, small and foreign equities has been just what the doctor ordered for this trying time. Before we all get too smug, let’s look at the longer term performance as a way to keep our expectations realistic.

Our purely hypothetical model for this discussion goes back to 1988, the first year we had data for all the asset classes. We include nine asset classes. In both domestic and foreign developed markets: large, small, large value and small value, plus a small weighting in emerging markets. The normal disclaimers apply: Past results are no guarantee of future results, no fees or expenses are included in the results, no particular investor held (or could have held ) the portfolio during the entire period.

First, lets review our equity investment strategy, and the rationale behind it. Over long periods of time there is a persistent, liberal additional return for assuming small company and distressed company risk. However, these returns do not occur reliably like clockwork. They show up randomly and can disappear for years at a time. If they were not random, there wouldn’t be risk, and you couldn’t expect an extra return.

Fortunately, they usually don’t all move in the same direction at the same time. In technical terms they have low correlation to each other. Adding categories with low correlation to each other reduces portfolio risk while enhancing returns, a practical application of Modern Portfolio Theory. Holding foreign equities in multiple categories spreads the risk even further.

All of this worked remarkably well since last April. The diversified portfolio did what we hoped it would do, preserve capital during a particularly rotten market. We might be forgiven for thinking we have discovered the silver bullet that kills portfolio risk.

Well, it’s not quite true. While we can reduce it, equity risk is never going to go away. Sometimes, in both good markets and bad, our various tilts will work against us. For instance, this portfolio mix would have substantially underperformed the S&P 500, an all domestic large company index, for every year between 1995 and 2000. It was a hard time to keep the faith. Diversification as an investment style came under sustained vicious attack.

At other times, during periods of acute market distress, nothing will work very well. For example, in the week after the September 11 attack on America, all global equity markets fell. (However, on a year to date basis, the model portfolio losses are a small fraction of the larger better known indexes.) Likewise, in another crisis period following Iraq’s invasion of Kuwait in 1990, small and foreign stocks were hit much harder than the S&P 500.

It was a dismal year for diversified portfolios indeed. Of course, during other periods, this model portfolio shined. During 1988, 1993, 2000 and so far in 2001, diversified accounts trounced the S&P 500. The very short duration of the model precludes us from “proving” our assumption that diversification increases returns. We actually had cumulative returns below the S&P 500 but experienced lower risk. Given the astounding run up of the S&P 500 during the last half of the decade, that result shouldn’t surprise us. If you think that the S&P 500 will continue to outperform the rest of the world indefinitely, then diversification isn’t for you. The rest of us who are interested in risk control should diversify.

Given these mixed results, what can we learn from this? Diversification is a superior strategy for long term investors. We have every reason to expect lower risk and higher returns over the long haul, but diversified portfolios:

  • Will look different from an investment in a single asset class. Sometimes that implies lower returns in the short term.
  • Cannot insulate us from all risk. Market risk is always present. Only the most naive would believe that any system or strategy could avoid it.
  • Cannot guarantee superior results. Especially in the short term results will vary greatly in even the most diversified portfolios.

Investors must have realistic expectations, focus on their long term objectives, and maintain discipline during discouraging periods in order to reap the rewards of even the most superior strategy. Diversification is the primary investor safeguard against all the things that might go wrong in the equity markets. But, its limits must be understood and respected.