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Diversification Works Just Fine.


Readers of Friday’s Financial Post may have read “Diversification’s dirty little secret”.

The article states that during the last six months, “The S&P 500 is down 15%, the S&P TSX 60 is down 20%, the MSCI EAFE, which includes developed markets outside the United States, is down 23% and the MSCI Emerging Markets is down 30%.” … but then concludes that, therefore, diversification doesn’t work.

The conclusion is simply wrong.

First, the markets mentioned are all ‘stock’ markets and are certainly all down but they aren’t down by the same amount. Clearly, these markets do not move in tandem. This is the very definition of diversification. No, they are not perfectly negatively correlated … the holy grail of portfolio management … but they do nevertheless offer some diversification. (These markets don’t move up in perfect lockstep either). Nowhere did anyone ever claim that stock markets would move in ‘exact opposite directions’. It’s always been a matter of degree.

Second, diversification has always (first and foremost) been about spreading ones eggs across ‘asset classes’. Traditional asset classes include stocks, bonds and real estate (usually REITs). The portfolio of stocks in the article is not a portfolio … it’s just a collection of stocks. (The article eventually gets to REITs but it’s too late … the damage is already done).

What have bonds and REITs done the same six month period?

Where’s the beef?

Canadian Universe bonds are up almost 8% and REITs are down -2.5%.  (See the iShares.ca index tracking tool).

Had the collection of stocks in the article been part of a properly diversified portfolio, the ‘portfolio returns’ would have been much more acceptable.

Given the following asset mix, the portfolio would have been down -7.94% … a much different and better conclusion.

Asset Class 6 month returns Asset Allocation Weighted Return
       
S&P/TSX 60 (Canadian stocks) -20% 20% -4%
S&P 500 (U.S.stocks) -15% 10% -1.5%
MSCI EAFE (Euro, Pacific) -23% 10% -2.3%
MSCI EM (Emerging Markets) -30% 10% -3%
S&P/TSX REITs -2.46% 10% -0.246%
DEX Universe Bonds +7.77% 40% 3.11%
Portfolio return     -7.94%

Data source: iShares.ca index tracking tool.

Fear not, dear Asset Allocators, diversification works just fine.

Next time?
More Risk Management.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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2 Comments Post a comment
  1. Thanks.
    The article author ought to know better.

    Like

    October 10, 2011
  2. Doug: Thanks for making this point, which is so often overlooked. I can’t believe how many investors think diversification just means being lots of stocks, while ignoring the asset classes that actually have some negative correlation (or noncorrelation) with equities.

    They might as well say that a balanced diet isn’t healthy, based on people who eat only beef, pork, lamb and venison.

    Like

    October 10, 2011

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