Ever since the financial crisis, many capital markets have seemed to move together. Though the truth is that major events have led to similar issues around the world, some commentators, in a self-serving fashion, have said that globalization has caused the world to become uniform and the benefits of diversification to disappear. The media have repeated this refrain and caused investors worry about their portfolios.
In fact, the benefits of diversification remain substantial and unchanged. What’s so surprising is that the evidence is right in front of us.
To demonstrate that there are still significant benefits to diversification, consider the returns of the past several years of the several broadly diversified mutual funds, when diversification supposedly wasn’t working.
In 2009, while U.S. large company funds returned 27 percent, emerging markets funds soared by 42 percent. Separately, international large value funds and international REIT funds outperformed their domestic counterparts by 10 percent and 8 percent, respectively.
In 2010, while U.S. large company funds returned 15 percent, emerging market funds surpassed that level by as much as 15.2 percent. This year the U.S. large, large value, small, small value and REIT funds exceeded their international counterparts by 5.7 percent, 9.6 percent, 6.8 percent, 12.8 percent and 10.6 percent.
In 2011, U.S. large, large value, small, small value and real estate funds outperformed their international equivalents by 14.4 percent, 19.8 percent, 12.2 percent, 20.8 percent and 7.2 percent respectively. U.S. large company funds outperformed emerging markets fund by about 24 percent.
If diversification was not working, we would not have witnessed such wide dispersions in returns.
In 2012, the relative performance of U.S. and international funds reversed with international funds outperforming their U.S. counterparts in every case. While we didn’t see as wide a dispersion of returns, there were still large differences. For example, international REIT funds outperformed the U.S. REIT funds by 15 percent, and the three emerging markets funds outperformed the U.S. large fund by from 3.4 percent to as much as 8.6 percent.
In 2013, through midyear, the relative performances once again reversed, with the U.S. funds outperforming their international counterparts in every case. Their U.S. large, large value, small, small value and REIT funds outperformed by 6.4 percent, 11 percent, 4.9 percent 5.1 percent and 2.9 percent, respectively. The U.S. large funds exceeded the emerging market funds by as much as 13 percent.
While it’s true that market movements, as measured by statistical correlation, have seemed similar, diversification across asset classes is still working quite well, at least for those who have the discipline to remain consistent in their plans.
The bottom line is that far too many investors succumbed to the wrong information, that diversification across risky assets doesn’t work any longer. The events during the financial crisis when correlations of all risky assets rose were only a temporary experience. The right lesson was that the most important diversification is to high-quality fixed income, making sure your allocation is high enough to dampen the risk of your overall portfolio to an acceptable level.
While the movements, correlations, of all risky assets may seem to respond similarly when we have the next crisis, the behavior of the safest fixed income investments is likely to move very differently.
For example, for the period 1926-2012, the movements of the S&P 500 Index versus long-term Treasury bonds were virtually unrelated. However, from 2000 through 2012, when the risky equities were moving together, the movements of long-term Treasuries to the S&P 500 were actually in opposite directions.
This explains why making sure that your portfolio has a sufficient allocation to the highest quality fixed-income assets is the most important diversification of all. A sound strategy will carry you through much of the turmoil so that you can be consistent.
Mark Sievers, president of Epsilon Financial Group, is a certified financial planner with a master’s in business administration from UC Berkeley. Contact him at firstname.lastname@example.org.