From the June 2009 issue of Wealth Manager Web • Subscribe!

Diversification: Always in Style

But since the end of 2007, the broad-based fall in equities has drained a mind-numbing $30 trillion of value from the stock market. Worse yet, amid the economic meltdown of 2008, investors were punished across essentially all asset classes--regardless of the level of diversification. Not surprisingly, then, reasonable people have been asking the question: Does diversification still work?

Yes, and unequivocally! It's just not a hedge against short-term loss.

Diversification is simply a way to enhance the risk/return profile of a portfolio over the long term. There are times, of course--like the tech meltdown of 2000--when it can provide meaningful downside protection. But the 2008 capital markets were a reminder--a painful one--that in times of stress, correlations often move toward 1.0. And that's when it gets tough.

As recently as our November 2008 Wealth Manager column (p. 43), we spoke of the outsized role human nature plays in the decision-making process during tumultuous markets. Similarly, well-known institutional investor Jeremy Grantham earlier this year warned investors against sheepishly moving their portfolios to cash in lieu of the opportunities that existed within the markets--a movement he called "terminal paralysis."

He specifically cited a six-month period in 1933 when the S&P 500 index jumped 105% from a perceived market bottom. His point, and ours, is that when investors panic out of an asset class and allow themselves to deviate from broad-based diversification, they risk missing out on the gains that inevitably follow.

In the first few months of 2009, we've already witnessed some relative return to normalcy. After 18 months of negativity, a number of asset classes turned positive for the quarter. And investors who heeded our (and Grantham's) advice favoring rational diversification were rewarded, particularly by a variance in the returns between developed and emerging markets, as well as a historically normal divergence between domestic stocks and fixed income.

As the stock market here moved from sideways to down, markets overseas advanced nicely. For example, after a 14% run-up in March, the MSCI Emerging Markets Index was ahead 1% for the first quarter, while China's CSI 300 Index jumped 36% and Russia's MICEX Index gained 25% for the period. But the more important story for the quarter may have been the reversal of fortunes for certain U.S. bonds, where domestic fixed-income indices such as the S&P/LSTA Leveraged Loan Index (+9.8%) and the Barclays Capital U.S. Corporate High Yield Index (+6.0%) that were punished in 2008 turned positive as fears over corporate liquidity were assuaged.

Of course, no one knows exactly when any asset class will turn. The task, then, is to maintain a truly globally diversified portfolio in order to capture returns when they do come. Attempting either to time the market or seek an assumed "safe" asset class will only result in frustration and hand-wringing.

To underscore our allocation thesis, we'll again quote Mr. Grantham: "...the market does not turn when it sees light at the end of the tunnel, it turns when all looks black, but just a shade less black than the day before."

J. Gibson Watson III is president and CEO of Denver-based Prima Capital (www.primacapital.com) which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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