The common refrain in the 2008-2009 credit crisis was that “correlations went to one” as seemingly everything dropped in price — U.S. stocks, foreign developed stocks, emerging market stocks, corporate bonds, mortgage-backed bonds, convertible bonds, commodities, real estate — the list goes on. Investors felt portfolio diversification had failed because, well, they lost money.
But to claim that diversification failed in 2008, you need to ignore that little-known $17 trillion market for Treasury bonds. The Barclays U.S. Treasury Index put up a nice diversifying return of 13.7 % in 2008.
As 2013 comes to a close, investors are disappointed by portfolio diversification yet again, believing that it has caused them to miss out on the out-sized gains earned in U.S. stock markets. The S&P 500 index gained 29.6% in 2013, outpacing just about every major asset class and country. Add in about 2% for dividends and the total gains are even higher. Holding any diversifying asset outside of U.S. stocks, from foreign stocks to bonds to cash to real estate to commodities, caused most investors to lag behind the major U.S. stock indexes.
Yet again, there is a notable exception to this storyline. Japanese stocks, which make up the largest stock market after the U.S., handily outperformed with the Nikkei index rising 56.7%. (Though to fully reap those rewards as a U.S. investor, you needed to hedge the currency — unhedged, the index’s gain was closer to 29%.)
So no, diversification did not really fail.
It’s a big wide investment world, and you can usually find exceptions to any narrative. The larger concern as we head into 2014 is that investors may decide that diversification is for the birds and will quickly jump into broad-market index funds or ETFs. That would be a mistake.
Portfolio diversification doesn’t guarantee positive returns in any and all markets. It also isn’t about trying to pick the best-performing asset — that’s market timing. If those were your expectations, well I’m sorry, but that’s not how diversification works.
Diversification means holding some assets that zig while others zag. When times are bad, you are going to feel it, but hopefully it won’t be as bad for you as it is for your under-diversified neighbors. And when times are good, you are going to participate but you won’t be able to brag as loud as your friend who claims to have called his investment in pork bellies perfectly.
Leave the cocktail chatter to someone else. Over time the combination of “less bad, but not quite as good” should result in a smoother ride and better investor experience.
Being diversified lets you benefit from, and protect against, a number of potential future outcomes. The year ahead is uncertain, as it always is. Portfolio diversification works.
Senior Editor Dan Wiener and Editor/Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.