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) 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.

Diversification might not help in the current cycle, Inker says. Most asset classes are fairly valued. It's unlikely that some categories will collapse as others soar.

"You should do all right in most asset classes," Inker says. "It's not stupid to put all your equity investment in large U.S. stocks because they are at fair value."

Most fund managers reject Inker's thinking. Donald Bennyhoff, senior investment analyst with Vanguard Group, says investors should blame poorly executed strategies for portfolio losses, not diversification.

Many investors believed they could lower the risk of owning stocks by holding many equity asset categories, Bennyhoff says. They thought a mixture of foreign and domestic stocks would be safer than a portfolio filled with U.S. companies. But foreign stocks often fall when the S&P 500 is declining.

"Trying to diversify stock risk by holding more stocks is not always effective," Bennyhoff says. "If you're risk-averse and you're trying to diversify the risk of stocks, then you need to hold Treasuries or high-quality bonds."

Should you ignore foreign stocks? Not necessarily, says Bennyhoff. If you put 10% or 20% of your equity assets into foreign stocks, you can enjoy some limited diversification benefits, he says.

"By adding foreign stocks, you may be able to lower a portfolio's volatility, but it's not certain that you will increase returns," he says.

Tim Noonan, managing director of private client services for Russell Investments, says investors should divide assets into two baskets. The first can include a classic mix of stocks and bonds. The second should be invested in annuities, insurance contracts that can provide fixed payments for a certain period, such as 20 years.

During bull markets, the diversified portfolio could outperform the annuities. In bear markets, the annuities would deliver steady income even if stocks collapse.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

If you liked this article you might like

Contrarian Sticks to His Guns

Contrarian Sticks to His Guns

Getting Ready for a Bond Bear Market

Getting Ready for a Bond Bear Market

GMO's Cautious Founder Finds Some Stocks to buy

GMO's Cautious Founder Finds Some Stocks to buy

GMO Discipline Rewards Investors

GMO Discipline Rewards Investors