Updated with correction
In the market events of 2008, some investors felt betrayed by the failure of diversification to avoid steep losses across asset classes.
Some have gone so far as to assert that diversification strategies failed plan sponsors in managing their pension funds. Not only is this not the case, but also diversification remains the single most important financial innovation of the past 50 years. Diversification has been a foundation of portfolio management for the better part of the last century.
After examining investor reactions to the extraordinary market turbulence and investment losses from 2007 through the beginning of 2009, I believe that there is a widespread misunderstanding of what diversification is and what it can be expected to achieve.
In the aftermath of these brutal market events, investors have the opportunity to reflect upon the value of diversification, weed out any misconceptions, and re-establish how it can be used effectively in portfolio management.
The goal of a diversified strategy is to reduce total risk and eliminate unsystematic risk — or those risks that are specific to a particular asset class. Yet allocating to different asset classes simply can't protect against all risk. Those risks that cannot be diversified away are the systematic risks inherent to all capital markets in aggregate.
Diversification is based on the belief that different asset classes are unlikely to move in the same direction over the long term. But as seen in 2008, unlikely does not mean impossible, especially over short-term horizons. We saw correlations among all asset classes spike upward dramatically, imparting a tough lesson: diversification strategies will not shield investors from systematic risk factors.
The non-diversifiable risk factors that manifested in 2008 were related to worldwide deleveraging and an overwhelming demand for liquidity.
These factors included the growth of the “shadow banking” industry, structured finance products and hedge funds. Together these forces catapulted the global financial system further out on the risk spectrum, particularly given the nature of the self-reinforcing positive feedback loops associated with money flows.
The degree to which these issues failed to be properly understood or observed by the various regulatory financial authorities further enabled a financial structure that was inherently unstable and unsustainable. Something had to give.
Diversification couldn't safeguard against these challenges, and the fact is we never should have expected it to as these challenges are elements of systematic, non-diversifiable risk spread across all asset classes.
So if diversification couldn't protect pension funds from systematic risk, why is it still the most important financial innovation? In the words of a wise colleague, “Diversification is admitting your ignorance and prospering.”
By admitting less than perfect foresight, diversification strategies allow the trade-off of possible exceptional returns for less remarkable returns with substantial risk reduction. Regardless of recent challenges to diversification, the fact remains that in the long term you will see superior risk return trade-offs so long as correlations are less than perfectly positive, that is, less than one.
Recognition of the long-term perspective is essential to understanding the value of diversification strategies. Plan sponsors must consider the appropriate time horizon for their plans and recognize that over short-term periods, many negative events can and will manifest themselves in the capital markets. The key to navigating through these events with a diversified strategy is proactive planning for how the investment strategy will adjust in response.
Holding fast to long-term forecasts and a diversified asset allocation strategy to ride out the storm isn't enough.
If there is one lesson to be learned from recent market events, it is that stress testing your plan and extensive scenario planning are crucial requirements. After the fact, it is clear that many sophisticated investors panic sold in response to the 2008 market events. This selling was dressed up in various forms of rhetoric and rationalization, but it was often rooted more in emotion than rational thought.
To avoid this costly behavioral mistake, plan executives need to institute forward-looking implementation policies to address certain negative events. If such events occur, you have an established plan anchored by your risk tolerance that can help guard against fear-based decision-making.
Depending on your plan's preferences and needs, introducing newer diversified asset classes and strategies such as alternative investments can be an excellent decision. These assets have typically low correlations with traditional asset classes, increasing the diversification effect.
For example, as bad as results were across the board in 2008, most hedge funds fared slightly better than the majority of traditional asset classes. According to Hedge Fund Research, Inc., the HFRI Fund Weighted Composite index showed a fund-to-fund return of -21.4% in 2008, compared with -37.3% in the broad market Russell 3000 index and -43.8% in the Russell Developed ex-U.S. Large Cap index.
Diversification continues to provide plan executives with the opportunity to abandon the pursuit of perfect foresight and still make profitable, strategically aligned investment choices. Yet moving forward, investors must retain a heightened awareness of diversification's capabilities and limitations and modify expectations accordingly.
The reduction in unsystematic risk that diversification offers does not mean we can ignore systemic financial problems, like those contributing to the major challenges we faced from 2007 to 2009. While these factors might have temporarily weakened the appeal of diversification, they should not deter plan executives from employing what remains a core element of successful investment management.
Erik Ogard is director of client investment strategies, Russell Investments, Tacoma, Wash.