Diversification is harder to achieve than before – but more important than ever
Theory and common sense tell us not to put all our eggs into one basket. But many asset classes move together increasingly closely these days, making diversification harder to achieve. That means it’s more important than ever to diversify portfolios sensibly.
A portfolio is said to be diversified if it includes a fair number of assets whose prices don’t move closely together (have low correlations with each other) because their values are determined by different factors. According to finance theory, a diversified portfolio should generate higher returns with smaller losses than a portfolio holding only a few correlated assets.
Thirty years ago it was easy to build diversified portfolios. The big asset classes – equities, government bonds and corporate debt – didn’t move closely together. And even within equities, the major markets (e.g. the US, UK, Germany and Japan) were only moderately correlated.
Over time, though, the world’s markets have become increasingly interconnected. The growth of trade, large-scale capital flows and superfast communications mean that many markets now move in lockstep, with the FTSE 100, for example, responding almost instantly to the latest news about Apple or US interest rates.
The graph below shows rolling three-year correlations between the MSCI US and the MSCI Europe indices, where a ‘1’ means they move together perfectly and ‘-1’ means they move in opposite directions. The correlation between US and UK equities reached a high during the 2008 financial crisis and has since remained elevated.
Other asset class correlations have also risen and seem to be staying up. In the 1970s and 1980s, for example, commodity prices used to move largely independently of equities. Then in the late 1990s investors began to invest in commodities on a large scale, viewing them as a proxy for global growth and spending, just like equities. Commodity prices have moved quite closely with equities ever since.
But the most important diversifier for an equity-rich portfolio is bonds. When equities crash, investors usually rush to the safety of high-quality government bonds, which then perform well for a while. This crucial correlation remains negative on the whole – as shown on the graph – and is still an effective way of diversifying a multi-asset portfolio.
IT CAN TAKE THREE TO FIVE YEARS TO SEE MANY OF THE BENEFITS OF DIVERSIFICATION
Few places to hide in a crisis
During the 2008 global financial crisis the benefits of diversification seemed to crumble. Most equity markets halved; corporate bonds, property and commodities were all weak; and multi-asset portfolios suffered across the MSCI US vs MSCI Europe ($) board. Diversification seemed to have failed just when investors needed it most.
This view is misleading, for two reasons. Firstly, government bonds performed strongly in 2008, so diversification did help a little in that year. More importantly, the benefits of diversification are really gained over longer periods. Emerging markets crashed in 2008, but raced ahead in the recovery after March 2009, while government bonds lagged behind. It can take three to five years to see many of the benefits of diversification.
And even if assets move closely together over short periods, their prices can trend in different directions in the medium term, driven by different fundamental conditions. For equities, these might include valuations, profitability, economic trends, productivity growth, and so on. In 2014, for example, the S&P 500 rose 14% while the FTSE 100 was down 2.7%. Though the two markets generally move in lockstep, holding both will generate smoother returns over the long run.
Diversifying portfolios effectively is harder now than it was 30 years ago, but that’s no reason to throw in the towel. If anything, it’s more important than ever to understand how different asset classes behave in different market environments and to maintain a sensibly diversified portfolio.