Portfolio Diversification May not be Enough in Bad Times

A month ago, I wrote a post on asset allocation where I discussed the importance of having a diversified portfolio that consists of various asset classes. The reason for doing that is quite simple: as we have long believed, diversification can mitigate risks.

When I was building my virtual all-ETF portfolio a while ago, I had this diversification idea on my mind and I picked some asset classes representing domestic large-cap, foreign, precious metal, REIT, and bond, etc. Back in August before the stock markets turned from bad to worse, my all-ETF portfolio actually did pretty well based on past performances of the components.

But that was then. Since the fall, stock markets took a nose dive as we have all seen. In this environment, does diversification do the job of mitigating risks? Looks like the result is disappointing because, well, everything basically went down, sharply. The following is a chart of 1-year returns of the equity components of my all-ETF portfolio, including SPDRs (SPY), iShares MSCI EAFE Index (EFA), Vanguard REIT Index ETF (VNQ), iShares S&P World ex-U.S. Property Index Fund (WPS), and SPDR Gold Shares (GLD).

As you can see, it’s an ugly chart. Except GLD, which is about broke even so far, all other investments performed much worse the the S&P 500 index. It’s quite evident from the chart that, at least in the short term, diversification failed to reduce risk and increase return.

Yesterday, I read a Reuters article with the title, When Diversification Fails, which pretty much says the same thing: “since the credit crisis began in August 2007, these alternatives fell in lockstep with, or sometimes faster than, equities, driving volatility higher and amplifying losses of a risky portfolio.” The reason is  correlations between different asset classes have increased. And since investments are getting correlated, they will move up or down at the same time, losing the ability to diversify.

Is the free lunch (using diversification to increase returns) really gone?

“Alternative investment has entered the main stream… Alternative is never going to be alternative again.”

It could be.

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