Your Best Shot At Diversification

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Financial advisers have long repeated some standard advice: To protect a portfolio, diversify the assets. But in the current downturn, many asset classes have dropped, and even broadly diversified investors have suffered sizable losses.

Seeing the red ink, some investors are throwing up their hands and concluding that diversification no longer works. In addition, one of the seemingly most reliable diversifiers -- bonds -- can seem like a snooze to many investors.

In fact, this bear market is hardly unique. During downturns, diversification provides only limited protection, according to a recent study by Peng Chen, president of Ibbotson Associates. The study also found that the impact of diversification has been changing in recent years.

According to traditional thinking, investors should own bonds and a mix of stocks, including foreign and domestic, large and small. For increased diversification, portfolios might also hold additional classes, such as real estate, commodities and hedge funds. Since some assets may be rising when others are in decline, diversified investors can avoid big losses, financial advisors have said.

For investors who relied on traditional strategies, this downturn has been frustrating because nearly all asset classes fell during certain periods. Some of the worst damage occurred during the six months from November through April. In that period, real estate funds lost 9.8%, according to fund tracker Morningstar. At the same time, large growth funds dropped 10.8%, while foreign large growth declined 10.5%. Supposedly safe ultrashort bond funds lost 2.1%.

Comparing recent experience with the past, Ibbotson's Chen examined correlations, a measure of how closely two assets track each other. The lower the correlation (1.0 is perfect correlation, 0 means there's none), the greater the diversification. If an asset has a high correlation, then there may be little reason to own it.



Ibbotson looked at how various assets tracked the S&P 500 from 1970 through March 2008.

During months when the S&P was rising, the foreign stocks of the MSCI EAFE index had an average correlation of 0.31. In other words, foreign stocks rarely tracked the S&P exactly.

But the picture changed during downturns. When the S&P was falling, the correlation with foreign stocks climbed to 0.53. Correlations for real estate investment trusts also spiked during downturns.

"In difficult markets, investors often sell all kinds of stocks and other risky assets at the same time," says Chen.

Besides rising during downturns, correlations can change over time. During the 1980s, foreign stocks typically had average correlations of less than 0.4 relative to the S&P. At the time, for instance, Japanese markets were soaring, sometimes climbing during periods when Wall Street languished.

But beginning in the 1990s, the correlations of foreign stocks began to rise. As global trade increased, stock markets were becoming more closely linked. With the Internet providing real-time information, traders around the world began reacting simultaneously. When word about the subprime mortgage crisis appeared, stocks fell in many countries. Now, the correlation of foreign stocks is 0.8. So foreign stocks only provide a small diversification benefit.

Since globalization seems likely to continue increasing, financial analysts argue that correlations of international stocks should remain high.

"It is not likely that the correlations will go back to the low levels of the past," says Steven Foresti, managing director of Wilshire Consulting.

Just as foreign stocks and real estate don't necessarily provide the diversification that investors may expect, other assets could also prove disappointing. One of the primary selling points of hedge funds is diversification -- the ability to make money in downturns. But many of the funds track the S&P 500 closely.

According to the Ibbotson study, the correlation between the S&P and the HFRI hedge fund index was 0.7. So many hedge funds provide only as much diversification as typical actively managed mutual funds.

"Most hedge funds hold a significant amount of equities," says Chen. "When the market goes down, hedge funds tend to correlate more with the S&P."

While hedge funds may provide limited value, commodities clearly help to diversify. As has been painfully apparent in recent months, prices of gold and oil can climb while stocks fall.

Still, researchers disagree about whether investors should hold commodities for the long term. The problem is that prices of commodities often bounce up and then eventually return to the initial level. The evidence is murky about whether commodity prices rise much over the long term.

In contrast, stocks definitely rise decade after decade.

"It is not clear that an exposure to commodities will be valuable for most long-term investors," says Christopher Jones, chief investment officer of Financial Engines, an investment advisory firm.

Faced with the mixed picture on diversification, what should you do?

Investors should start by being globally diversified, holding foreign and domestic stocks, says Scott Donaldson, senior investment analyst for Vanguard Group. Even though correlations are rising, it pays to own a broad range of stocks.

"There are times when the U.S. markets drop, and the Europeans lose less," Donaldson says. "As long as U.S. and foreign markets are not perfectly correlated, then there is a diversification benefit."

Along with stocks, investors should also own bonds, says Donaldson. During the past decade, bond correlations have dropped. In many instances, bonds have risen while stocks were falling. This year, Treasuries and other investment-grade securities climbed as stocks dropped.

In the future, there is no guarantee that bond correlations will continue falling. But for the time being, bonds remain one of the most reliable diversifiers.

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