The Limits of Diversification

August was a very volatile month, but stocks ended up on a high note. While the S&P 500 fell by 5.7% for the month, the index ended up 8.8% higher than its low on August 8. After a month like this, many investors ask “should I have done something different with my portfolio?” Of course, the easy answer is “yes, I should have seen this decline coming and put all of my money into a money market fund.” But that is playing the perfect hindsight game; these types of declines are not forecastable, and moving all of your funds into money markets will damage the potential of reaching your long-term objectives. Unfortunately, more investors tend to move into money markets after a market decline (for example, on August 8), than before the drop in values.

A more realistic consideration is should you have diversified your portfolio more broadly? Most advisors, TSG included, recommend that investors diversify their holdings across various asset classes to reduce risk. So perhaps you should have most of your money in these other assets classes to protect you from stock market declines. The usual suspects for diversifying asset classes are small company stocks, international stocks, emerging market stocks, real estate, and commodities. The data below shows how the diversifiers perform over the past month.

Asset Class (August Return*) Small company stocks (-8.8%) International stocks (-11.2%) Emerging market stocks (-9.3%) Real estate investment trusts (-5.8%) Commodities (-3.4%)

So the investments commonly used to diversify a portfolio also fell in value over the past month. Indeed, each of those diversifying investments, held individually, is riskier than the S&P 500 – for example, during the market downturn in 2008, all of them had a significantly steeper price decline. Looking to move the majority of your investments into an alternative such as emerging markets or commodities simply adds to your portfolio’s risk. Alternatives need to be added subtly to properly diversify an investment plan.

Diversification across asset classes does not often work very well during short-term periods – the concept is designed to work over a long-term time horizon. Moreover, an understanding of the risks and correlations of asset classes is needed to appropriately develop an asset allocation. When properly constructed, a broadly diversified portfolio can accomplish two objectives – enhance long-term return (investments such as small company stocks and emerging markets have provided higher long-term returns than large company stocks), and reduce long-term risk. Each of those investments will fluctuate up and down, but over the long-term a strategically balanced portfolio should have a smoother path.

* The returns are measured using the following indexes: Russell 2000 for small company stocks, MSCI EAFE for international stocks, MSCI Emerging Markets for emerging markets, Dow Jones REIT for real estate, and S&P GSCI for commodities.