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25 May 2010
Is diversification dead? Or are we looking in the wrong places?
The financial planning world is abuzz with discussions about whether diversification--that is, holding different kinds of assets in a portfolio--works as well as we thought it did. In 2008, the indexes representing U.S. and international stocks, commodities and real estate all went down. In 2009, they all went up. The idea that some assets zig while others zag--leveling out the rollercoaster ride of market ups and downs--seems to be broken.
But is it? In a recent interview in Investment Advisor magazine, Yale University finance professor Roger Ibbotson pointed out that in 2008, about 25% of U.S.-listed stocks lost at least 75% of their value. But only four of the more than 6,600 open-ended mutual funds that invest in U.S. stocks lost more than 75% in 2008. Holding a variety of stocks--diversification--cushioned the impact, which could have been quite severe if your entire portfolio had consisted of one of more than 1,000 stocks that went into free-fall.
Meanwhile, the May 1-2 issue of the Wall Street Journal, in the Weekend Investor section, reports that investors who held small company stocks as well as large ones didn't suffer quite as badly through the so-called "lost decade" of stock market returns. For the full decade beginning January 1, 2000, the large-cap S&P 500 index fell nearly 18%, a loss of almost 2% a year. Over the same ten-year time period, the small-cap S&P 600 index gained nearly 100%, producing an annualized return of 7.1% a year.
Nobody could have predicted that small cap stocks would do so well or that large caps would do so badly. Investors who owned both escaped some of the pain; for them, the "lost decade" wasn't a total loss after all.
