Diversification Is Back
NEW YORK (TheStreet) -- Long-term focused, strategic investors have been granted an early wish this holiday season: diversification has made a comeback. The return of the effectiveness of this important investment risk management strategy is a welcome gift as investors look toward 2011.
In 2008 and 2009, most markets moved together as the outlook for all financial assets was tightly linked to the global financial crisis and recovery. Diversification offered little cushion to investors in the second half of 2008 as markets plunged. And, again as the recovery got underway in 2009, markets uniformly turned around and rose.
However, during 2010 glimmers of the impending return of diversification became evident. In May and June, as stocks and commodities fell, bonds steadily rose in value. And, again, in November and December, as stocks and commodities surged, bonds fell. For example, stocks are up 9% in the fourth quarter (as measured by the
S&P 500 Index
) while bonds are down -2% (as measured by the
Barclays Aggregate Bond Index
), as the year draws to a close.
Of course, a key potential benefit of having the investments in your portfolio behave differently is that overall volatility is muted. Muting portfolio volatility can be especially valuable when taking distributions from a portfolio. High volatility can shave years off the lifespan of a portfolio paying stable distributions since a larger percentage of the portfolio must be sold after the value of the portfolio has fallen in order to pay out the same amount. After the wild swings among all markets in recent years, this moderating force provides a confidence boost when it comes to managing risk and making more linear progress toward achieving investment goals.
Globally, financial markets are showing more independence from each other economically and in terms of performance. Two years ago, the countries of the world all plunged into a downturn in the first globally synchronized business cycle. However, two years later, there are very notable differences among the world's economies. In addition, markets are responding to these differences. This is not just true for the emerging markets compared to developed markets, even within these similarly grouped markets, there are stark differences.
For example, in the emerging markets, Greece is a lot different from Brazil. Both countries suffer from completely opposite problems when it comes to growth and attracting foreign capital; Greece has too little of each and Brazil too much. In developed markets, Europe is in a very different economic position compared to developed peers such as Canada and Australia who are growing much faster and are benefitting from the rise in commodity prices. Finally, it is obvious that the United States is economically much different from China.
This return of the benefit of diversification was not limited to the major asset classes. Within the stock market, diversification has started to increase as individual stocks have started to move more independently of the overall market. In recent years, the 500 company stocks that comprise the S&P 500 index generally moved in lock step with the overall index, providing less diversification. However, the correlation, or degree to which the individual stocks move in sync with the index, is beginning to fall. This illustrates that portfolio diversification is making a comeback from the bottom up, as well as the top down.
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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.
Jeffrey is Chief Market Strategist and Executive Vice President at LPL Financial.