Diversification is no panacea for investor risk

Research shows in short-term market panics few stocks are spared

Diversification reduces risk of long-term disappointment, but avoiding short-term pain is another matter entirely. Photograph: iStock

Diversification reduces risk of long-term disappointment, but avoiding short-term pain is another matter entirely. Photograph: iStock

 

Diversification is often referred to as the only free lunch in finance but it didn’t protect investors from a shellacking in 2018, with almost all major assets classes – from stocks around the world to corporate bonds and commodities – disappointing investors. In times of trouble, risky assets everywhere tend to head south, prompting the question: is diversification overrated?

Advocates of diversification would say such a conclusion is premature. After all, 2018 was extraordinarily atypical in that almost all asset classes either fell or eked out meagre returns. The sheer breadth of declining asset classes made it the worst year for making money since 1972, according to Ned Davis Research.

Even during the global financial crisis in 2008, diversified investors could have reduced their losses by holding government bonds and gold. Still, it’s true to say that in panicky markets a diversified equity portfolio is likely to get bruised and battered.

In early 2018, US indices suffered a double-digit correction; globally-diversified portfolios offered no protection, with non-US markets suffering even bigger falls. US markets soon calmed down before a second and much bigger panic took hold in October. Again, stocks plunged around the globe, with all developed and emerging markets suffering heavy falls.

Contagion

Such action is all too common, Barclays commented in its outlook for 2019. European stocks look much cheaper than their US counterparts but that’s unlikely to protect them in the event the US market suffers another selloff in 2019, cautioned Barclays. In fact, US economic data is a bigger driver of European stock markets than European economic data.

As a result, when the US experienced a “mini-industrial recession” in 2016, European stocks also sold off. Similarly, US growth slowed before European growth when the dotcom bubble burst in 2000, but European stock returns tracked US growth much more than European growth.

Market history suggests exposure to cheaper European equities will not protect investors in the event of another US selloff, suggests Barclays, given that European corrections tend to be “comparable or worse” than those seen across the Atlantic. Global equities are just that – global. When stocks tank in one region of the world, the panic tends to spread to other parts of the world.

Consequently, “diversification seems to disappear when investors need it the most”, note US money managers Sébastien Page and Robert Panariello. When Diversification Fails, a paper published by the pair last May in the Financial Analysts Journal, describes this as “one of the most vexing problems in investment management”.

The co-movement of different national indices can be measured by their correlation score. For example, a positive correlation score of 1.0 between two different indices would mean they are perfectly correlated and that their performance is identical. Page and Panariello found that, historically, correlations fall dramatically in good times.

During a strong US bull market, for example, the correlation with non-US markets fell to as low as -0.17. However, correlations typically spike higher in times of crisis, with correlations soaring to +0.87. In other words, diversification “seems to work remarkably well when investors do not need it – during market rallies”. During market crises, however, “diversification across risk assets almost completely disappears”, with stocks falling in unison.

Free lunch?

So is diversification really the only free lunch in finance to use the oft-quoted expression coined by Nobel economist Harry Markowitz? International Diversification Works (Eventually), an award-winning paper co-authored in 2011 by high-profile hedge fund manager Cliff Asness, which examined international equity returns over the 1950-2008 period, concedes that a diversified portfolio will not protect you from short-term crashes. During the infamous market crash in October 1987, for example, US stocks fell by 21.4 per cent while a global portfolio of 22 equity markets fell by 21 per cent.

Although it’s true to say markets crash together over the short term – over a one-month holding period, there is little difference between the performance of a national stock index (for example, the Iseq in Ireland) and a global portfolio – this observation “misses the big picture”, says Asness. Over the long term, he noted, markets don’t tend to crash at the same time.

Short-term market downturns “are, at least partly, about panics and broad-based selling frenzies”, but long-term returns are more about the economic performance of different national economies. As a result, some national markets experience miserable performance – the most obvious example is Japan, where equities even now remain well below 1989’s all-time high – but others shine.

Risks

The same point is made by financial blogger Ben Carlson of Ritholtz Wealth Management. Diversification is not about avoiding market volatility or protecting you from terrible months in the markets, says Carlson; it is about protecting you from terrible results over long-time horizons and spreading your risks.

Irish investors who bet heavily on their home market during the Celtic Tiger years are still paying the price, with the Iseq index more than 40 per cent below its 2007 high. UK, European and emerging market stocks have also performed horribly over the same period, but US indices have soared.

Things were very different between 2002 and 2007, notes Carlson, when European and Pacific stocks trounced their US counterparts. The 1990s were good ones for the US, with the S&P 500 generating annualised returns of 12.9 per cent, but the MSCI EAFE index – a measure of developed markets outside the US and Canada – averaged annual returns of just 2.7 per cent over the same period.

However, that same index delivered very handsome annualised returns (16.9 per cent) between 1970 and 1989, easily beating the US market over the same period. Since 1970, developed markets outside the US have outperformed American stocks in 25 out of 48 years and underperformed in 23 years. More importantly, there can be long periods of “severe underperformance” if you invest in a single geographic region, says Carlson, so it “makes sense to diversify globally and avoid a home country bias”.

Investors might be surprised how long these periods can be – data from Credit Suisse’s annual Global Investment Returns Yearbook shows that countries such as Japan, Germany, Spain, France and Italy have all experienced periods of 50 years or more where stocks lagged inflation, so the dangers of an undiversified portfolio shouldn’t be underestimated.

Limits

However, it’s important to remember that equity diversification has its limits.

Investors like the idea of a diversified portfolio to cushion losses in times of trouble, but the research shows few stocks are spared during short-term market panics.

Recent months have reminded investors, both diversified and undiversified, that market downturns can be painful affairs. Diversification reduces the risk of long-term disappointment, but avoiding short-term pain is another matter entirely.

The Irish Times Logo
Commenting on The Irish Times has changed. To comment you must now be an Irish Times subscriber.
SUBSCRIBE
GO BACK
Error Image
The account details entered are not currently associated with an Irish Times subscription. Please subscribe to sign in to comment.
Comment Sign In

Forgot password?
The Irish Times Logo
Thank you
You should receive instructions for resetting your password. When you have reset your password, you can Sign In.
The Irish Times Logo
Please choose a screen name. This name will appear beside any comments you post. Your screen name should follow the standards set out in our community standards.
Screen Name Selection

Hello

Please choose a screen name. This name will appear beside any comments you post. Your screen name should follow the standards set out in our community standards.

The Irish Times Logo
Commenting on The Irish Times has changed. To comment you must now be an Irish Times subscriber.
SUBSCRIBE
Forgot Password
Please enter your email address so we can send you a link to reset your password.

Sign In

Your Comments
We reserve the right to remove any content at any time from this Community, including without limitation if it violates the Community Standards. We ask that you report content that you in good faith believe violates the above rules by clicking the Flag link next to the offending comment or by filling out this form. New comments are only accepted for 3 days from the date of publication.