Diversification Fails Under Fear Contagion

Modern portfolio theory demands a high level of diversification to reduce unsystematic risk. Yet, the high level of fear contagion seen throughout 2008 led to increased correlations among asset classes. The positive effects of diversification seen from the beginning of the decade changed dramatically when the U.S. stock market topped in October 2007 and fear overwhelmed. The interconnectedness of global financial markets has made it more and more difficult for investors to find uncorrelated assets to reduce the volatility of their portfolios.

An investor looking to completely diversify his portfolio under current prevailing theory could own the following asset classes: domestic stocks, international stocks, emerging markets, bonds, real estate and commodities. The chart below shows returns on these asset classes from 2001 up to the U.S. stock market top in October 2007. Returns from the various asset classes ranged from up 350% in emerging markets to down slightly in U.S. bonds. The diversification worked to reduce volatility while exposing the investor to the meteoric gains seen in the emerging markets.

The top in the U.S. stock market led to a dramatic fall in nearly all asset classes. U.S. real estate performed the worst falling almost 70% while U.S. stocks, international stocks and emerging markets all dropped over 50%. Commodities initially provided strong diversification benefits as the bubble inflated into the summer of 2008. Yet, as investors saw the global economy slowing, commodities caught up ending 40% lower erasing the 40% gain earlier seen. The only diversification benefit seen was the U.S. bond market which eked out small gains offering preservation of capital.

These findings point to the need for most investors to hold a portion of bonds in their portfolio. The increasing interdependence between global economies reduces the benefits of global diversification. Even asset classes, such as real estate and commodities, become highly susceptible to correlated falling prices in a slowing economic environment. Diversification is certainly important but may not offer the protection many would hope to receive.