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SJun 3, 2011

Yes, Diversification Works

Scott Burns
Yes, Diversification Works

The idea of diversification has been under attack since the market collapse. It’s not hard to see why. Whatever you owned in 2007, it went down in 2008 and early 2009. You couldn’t escape the domestic crash by owning stocks in Europe or Asia. You couldn’t escape by fleeing to obscure emerging markets. The paddy wagon came and it took all the girls.

Preparing to speak to a recent gathering of the Seattle chapter of the American Association of Individual Investors, William Bernstein provided a dramatic summary of the universal crash. Dr. Bernstein is the author of two classic books on investing, “The Investor’s Manifesto” and “The Four Pillars of Investing.”

From June of 2007 through February of 2009, stocks in every category crashed. The S&P 500 fell 49.7 percent

  • Domestic large cap value stocks fell 60.6 percent
  • Domestic small cap value stocks fell 61.1 percent
  • REITs fell 68 percent
  • Large International stocks fell 52.8 percent
  • International large cap value stocks fell 60.8 percent
  • Emerging markets stocks fell 49.6 percent
  • Domestic micro stocks, international small cap value stocks, emerging market value stocks and emerging market small cap stocks also declined similar amounts.

Wherever you tried to hide, diversification didn’t protect you from a loss in equities. Diversifying from stocks with some fixed income provided a little protection, but not nearly enough to overcome the crash of common stocks, regardless of market. In 2008, according to Morningstar data, the average large cap blend fund lost 37.8 percent. The average intermediate term government bond fund gained only 5.5 percent.

The debacle gave a new reason for living to the market-timing crew. These are the folks who will give us a peek at their crystal ball if we subscribe to their newsletter, become their fee-paying clients or listen to their prognostications on TV. It’s hard to argue against them when you are measuring by this particular (and short) time period. When there is a real market crash, everything goes down.

But what happens, Bernstein asks, if we look at a longer and more meaningful time period? Would that change things? Would diversification have offset some of the losses and misery in the domestic equity market?

His answer: You bet.

Change to a longer time scale and the benefits of diversification become very clear. Moving from a slide showing short term changes to a slide showing long term changes, Bernstein shows that the ownership of anything beyond the S&P 500 would have brought significant positive change to your portfolio.

Between January of 2000 and December of 2009, for instance, the S&P 500 provided a total return of minus 9.67 percent. That’s a 10 year loss that absolutely everyone knows about. But look what other categories of equities returned over the same period:

  • Domestic large cap value stocks returned 53.7 percent
  • Domestic small cap value stocks returned 139.5 percent
  • REITs returned 170.9 percent
  • Large cap international stocks returned 15.1 percent
  • International large cap value stocks returned 90.7 percent
  • Emerging markets stocks gained 147.8 percent
  • Domestic micro-cap stocks, domestic small cap value, international small cap value, emerging markets value stocks, and emerging markets small cap stocks all enjoyed enormous gains. Emerging markets value stocks, for instance, returned 266.7 percent.

As a consequence, any investor who was reasonably diversified might have lost money during the crash, but would be far better off if they had been diversified through the decade.

One indication is Craig Israelsen’s “7Twelve Balanced portfolio.” The subject of an earlier column, the Brigham Young University professor’s model portfolio is built using a dozen equal-sized investments in a broad selection of asset classes. Basically, it is a globalized update of a traditional domestic balanced fund. It’s also easy to build and rebalance since it uses the same equal-sized investments as my Couch Potato Building Block Portfolios. That means it is something you and I can do, as they say, “in our spare time, at home.”

How big is the difference?

Vast. An update of his paper “A Better Balanced Fund” shows that the S&P 500 provided a piddling annualized return of 1.32 percent over the 10 years ending December 31, 2010. That’s less than the dividend yield of the index during the period.

During the same ten years the Vanguard Balanced Index fund (domestic stocks and bonds) returned 4.13 percent. But the fully diversified 7Twelve portfolio returned twice that, an annualized 8.49 percent.

That’s quite a difference.

Filed Under: Retirement