Does Investment Diversification Pay?

Last year's stock market downturn spawned heated debates about the effectiveness of diversification. While most fund managers and financial advisers continue to defend the strategy, a growing chorus is challenging traditional views.

Among the most frightening aspects of last year's stock market meltdown was the fact that nearly everything fell, including stocks, commodities, real estate and most bonds. Investors who spread their bets, as finance textbooks recommend, suffered big losses.

"In the kind of difficult market we saw, you had to do more than simply hold the standard mix of stocks and bonds," says Diane Pearson, an adviser with Pittsburgh-based Legend Financial Advisors.

Mainstream thinking on diversification dates back to the 1950s, when Nobel Prize-winning economist Harry Markowitz said the strategy could limit risk and maximize returns. Many pension funds and institutions adopted his view and put 60% of their assets in equities and 40% in bonds, holding the allocation for decades.

Diversification proved particularly helpful during the downturn that began in 2000. While the S&P 500 Index dropped 9.1% that year, small value funds returned 19%, and real estate funds climbed 27%.

Last year, diversification provided little protection because almost every asset class was overvalued, says Ben Inker, manager of the Evergreen Asset Allocation Fund(EAAFX Quote) and director of asset allocation for Boston-based GMO. His firm has achieved a strong long-term record by regularly shifting holdings, adding more to cheap assets.

To spot bargains, GMO estimates the fair values of securities based on their cash flow. In the late 1990s, GMO steered away from growth stocks and put 10% of its assets into real estate, unloved at the time. By 2006, the money manager had pulled out of the red-hot real estate sector.