Your Best Shot at Diversification

Financial advisers have long repeated some standard advice: To protect a portfolio, diversify the assets. But in the current downturn, many asset classes have dropped, and even broadly diversified investors have suffered sizable losses.

Seeing the red ink, some investors are throwing up their hands and concluding that diversification no longer works. In addition, one of the seemingly most reliable diversifiers -- bonds -- can seem like a snooze to many investors.

In fact, this bear market is hardly unique. During downturns, diversification provides only limited protection, according to a recent study by Peng Chen, president of Ibbotson Associates. The study also found that the impact of diversification has been changing in recent years.

According to traditional thinking, investors should own bonds and a mix of stocks, including foreign and domestic, large and small. For increased diversification, portfolios might also hold additional classes, such as real estate, commodities and hedge funds. Since some assets may be rising when others are in decline, diversified investors can avoid big losses, financial advisors have said.

For investors who relied on traditional strategies, this downturn has been frustrating because nearly all asset classes fell during certain periods. Some of the worst damage occurred during the six months from November through April. In that period, real estate funds lost 9.8%, according to fund tracker Morningstar. At the same time, large growth funds dropped 10.8%, while foreign large growth declined 10.5%. Supposedly safe ultrashort bond funds lost 2.1%.

Comparing recent experience with the past, Ibbotson's Chen examined correlations, a measure of how closely two assets track each other. The lower the correlation (1.0 is perfect correlation, 0 means there's none), the greater the diversification. If an asset has a high correlation, then there may be little reason to own it.