Diversification works great...until it doesn't

Many financial advisers tout the benefits of diversification. They reason that spreading your eggs among many baskets can protect your aggregate egg count in case one basket drops.

But, what if there is some underlying reason that causes all baskets to drop all at once? Then, of course, all your eggs drop.

Most people didn't think this was possible, and yet it happened in 2008. Almost every asset class dropped as the market panicked. The one major exception was U.S. Treasury Bonds.

As John Authers put it in his "The Short View" column in the Financial Times, "...last year's sell-off was so extreme that diversification would not have helped one whit."

But, isn't it at times like this, when everyone is panicking, that diversification is supposed to provide benefits? Yes, it is supposed to. But, that doesn't mean it does.

The reason why is that all financial markets are linked. Just because everyone is running from one investment does not mean another "historically uncorrelated" asset is necessarily doing well. This was very clear in 2008.

Diversification seems to work best when you don't need it. People don't get excited about diversification during normal times. It just gives you average instead of slightly better or slightly worse returns.

If you have half your money in U.S. stocks that provide a 5% return and half your money in foreign stocks that provide a 15% return, you get 10% returns. All you manage to do is lock in mediocre returns all the time. Getting 5% returns versus 10% or 15% returns in a single year won't ruin someones retirement. Losing 40% the year after retiring almost certainly will.

When markets really panic, everything goes down together. Even a brief glance at economic history confirms this. Diversification fails when people want it most. Like...well, like in 2008.

There is a very real benefit to be gained from this situation, though. Not all investments have bad underlying characteristics. The very fact that a panic has occurred means both good and bad investments were sold off. So, you can currently buy excellent investments for the same price as the poor ones.

But, if you diversify you'll get both the bad and the good returns going forward. Someone down 40% will see a world of difference between getting a 67% return (being in the good investments and returning to starting principal value) and getting a 33% return (being diversified in half the good investments that go up 67% and half the bad investments that go nowhere, thus still being down 20% from starting principal value).

Or, as John Authers put it, "If there is any consolation, it is that the sell-off was so indiscriminate. The odds are overwhelming that some stocks and asset classes will now begin to outperform."

I don't know when, exactly, those good stocks and asset classes will take off, but I'm quite comfortable I have identified them and believe very strongly my clients and I will benefit going forward.

This may very well be a case where not being too diversified will reap great benefits.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.