The Benefits of Diversification: Myth or Reality?

Modern Portfolio Theory, developed in 1952 by Harry Markowitz, has been the gold standard used by most advisors in financial planning and investment portfolio planning ever since. It has stood the test of time both theoretically and empirically. This theory makes the case for the “efficiency” of securities markets, and the corollary concept of diversification. According to this concept, diversification of a portfolio achieves reduction of risk without a commensurate reduction in performance, or return. For investors of modest means, the size of a portfolio necessary to achieve adequate diversification through ownership of individual stocks and bonds is beyond reach. Fortunately, the mutual fund industry makes diversification possible for the affluent and the less-affluent.

According to this concept, two or more assets with equal average long-term growth performance can be combined, maintaining the long-term return performance expectations of each while collectively reducing the variability below that of each of the assets. This is possible because the assets themselves lack correlation to each other. That is, they respond differently to market stimuli. Some assets move positively when others move negatively. In other cases, some move a little while at the same time, other assets move aggressively. This is particularly true of major asset classes, such as stocks vs. bonds vs. commodities, but is also true, maybe to a smaller scale, within those categories, such as large cap growth stocks vs. small cap growth stocks.

Until 2008, empirical evidence supported this theory that different asset classes reacted differently to certain stimuli. In both expansions and contractions of the economy, even through previous times of crisis, different asset classes retained their character of non-correlation to each other. Some now argue that the recent global crisis has rendered Modern Portfolio Theory invalid.

The near collapse of the global financial system since mid-2008 admittedly seemed to violate this tenet of modern portfolio theory. I disagree. So many factors conspired at once in this financial disaster, that the case can be made that such an event is what is known as a “black swan” event, and is unlikely(hopefully) to recur in our lifetimes. For the previous five decades, every financial “crisis” resulted in at least one asset class which could be considered a safe haven while another asset class was under stress. This most recent crisis exhibited no safe havens—virtually all asset classes dropped in value at the same time, i.e. all exhibited correlation to each other. There was no safe haven from this crisis, other than putting cash under the mattress, which is no asset class at all. Only time will tell whether or not the diversification theory of non-correlation was truly violated.

I submit that it is prudent to plan as if such an event was “black swan”, and that we should plan for normal crises in the future, those that will not invalidate the theorem of the value of diversification of non-correlated assets. Besides, if we don’t accept this concept for our future investment planning, to which theory should we subscribe?

Clifford Caplan argues in the November, 2009 edition of Financial Advisor that we have experienced other fairly recent black swan events. According to Caplan, “examples of highly improbable yet calamitous events are Black Monday (1987), 9/11 and, of course the 2008 meltdown”. He also makes the case that it is prudent to plan for such black swan events. He correctly points out that those who possess such knowledge of upcoming future calamities can respond accordingly. If the response is appropriate, very small changes or investments can result in homeruns from a financial perspective. But even Caplan claims that “almost all consequential events in history arise from the unexpected”.

If such events are truly unexpected, then who can we trust to make accurate predictions? If we don’t know, and who does, then it would only be prudent to hedge our bets and react to the predictions of many. Such a course of action is analogous to betting on every horse in the race. Caplan points out some who did predict the 2008 collapse. Did those same persons predict the Asian currency crisis of 1997, Russia’s 1998 Treasury Bill default, Black Monday, and 9/11? We had a saying in business school that economists predicted eleven of the past three recessions. I think such an analogy is appropriate here also.

I don’t believe that the events of the global meltdown of 2008 can be compared to events such as 9/11, Black Monday, the collapse of Long Term Capital Management or the Savings and Loan crisis of two decades ago. In each of those cases, a viable safe haven for investments existed. As such, none of those crises invalidated the power of diversification. To the contrary, they supported the concept.

There is a growing school of thought that the actions of the governments around the world in the latest crisis, while serving to shorten and reduce the extent of damage of the “Great Recession”, short-circuited the cleansing process necessary to correct the excesses which initially brought on the recession. If so, the ingredients behind the recent calamity may yet still exist to bring on yet another calamity, maybe even another black swan event. Such ingredients include huge trade imbalances which create artificially cheap credit, a lack of regulation, particularly over investments such as derivatives and hedge funds, and the creation of investment vehicles backed by illiquid assets, such as credit default swaps and collateralized mortgage obligations(CMO’s). The Obama administration professes it’s mandate to achieve such regulation, and we can only hope that it will successfully do so in an efficient manner. The regulator’s role is one of containing illegal and reckless activities, while allowing for healthy risk-taking and creativity. That is a tall order, but the definition of effective and efficient regulation. It is incumbent upon investment advisors to monitor such events. I believe that this is the prudent course for advisors, not the anticipation of future black swan events.

One overriding trend has been taking place for over 30 years, one whose back was broken in the recent crisis. That trend is the artificial growth of home equity, the resultant risk-taking fueled by over-confidence and financial leverage of the consumer through unsustainable debt loads. The belief in the 1970’s was that it was good for our society and our economy to increase homeownership among the population. Despite the merits of this ideal, the actions taken by our government to make this goal a reality were ultimately destructive, the price of which we’ve been paying since early 2008.

The legislation which unleashed this trend was the Community Reinvestment Act of 1977. The government had ways to influence banks to make mortgages available to those who weren’t really sufficiently qualified, those who lived in blighted areas of major cities. As long as home prices kept climbing, the banks never suffered the consequences. After decades of comfort with looser credit requirements and cheap money, the financial services industry was offering sub-prime mortgages to poor credit risks using complex investment vehicles under terms of no money down, no-doc mortgages and interest-only payment plans. And home prices increased for almost 30 years unabated. The stage was set for what we now know as the “Great Recession”.

Despite good intentions to identify the causes of the excesses involved and to fix them, the partial rebound of the stock market in 2009 has the risk of weakening the resolve for solution. Unfortunately, it appears to me that the driving force for many Wall Street firms to repay the TARP bailout funds to the federal government is to gain the freedom to offer outlandish bonuses to those who engage in risky activities. The populist agenda of the Obama administration is attempting to address this problem currently. Even partial success, combined with the unlikelihood of seeing another housing bubble within a generation of the magnitude we’ve just experienced, greatly reduces the chances of another such “black swan” event for the foreseeable future. This simply supports the wisdom of continuing to employ modern portfolio theory to drive asset allocation decisions in investment planning. The events of 2008 do tend to violate MPT during events so dramatic that they fall into the “black swan” category. But almost by definition, such events are so rare and massive that they cannot, and should not, be predicted and used to drive investment decisions. Diversification works in normal times, with normal expansions and recessions. We must keep a wary eye on developments in the financial services industry and legislation to add much needed regulation. Failure to learn from our past mistakes increase the risk of another calamity in which all asset classes will exhibit correlated results, thereby once again rendering the intended benefits of diversification moot. I believe that for the most part, notably with the notable exception of Wall Street executives, we recognize our past mistakes and will institute repairs. They say there are two things one should not witness being created: sausage and legislation. Such legislation to repair our financial regulatory systems will not be without angst and will not, of course, be passed with unanimity. Any repair created by our democratic system is unlikely to be perfect, but it will likely be sufficient.