Too-Great Expectations

What went wrong with diversification was what always goes wrong with it in tough markets. Money managers — and, yes, some financial journalists — oversold diversification as a rock-solid bulwark against losses when all it ever has been is a strategy to reduce, not eliminate, risk. In a bear market, you’ll still lose money, just not as much as you would have had you not diversified. And expecting a diversified portfolio to shield you from short-term losses when virtually every market has taken a hit is expecting too much.

In other words, the dirty secret of diversification, which almost no one talked about during the boom years, was that it works least when you need it most. “All risky asset classes tend to go down together in a global economic downturn,” says Rick Ferri, author of All About Asset Allocation and founder of Portfolio Solutions LLC, a Troy, Mich., money management firm. Now they tell you.

Another problem is that you may have had short-term hopes for what’s a long-term strategy. Consider how a portfolio of 70 percent U.S. stocks and 30 percent long-term U.S. government bonds fared over the 81 years through 2007. This portfolio earned an average annual return of 9.3 percent, slightly less than the S&P 500’s 10.4 percent gain, according to Ibbotson Associates. But the 70/30 portfolio achieved its return with dramatically lower volatility. The stock/bond mix lowered risk by nearly 30 percent, while giving up only 1.1 percentage points of return. Not a bad deal.

All Together Now

Yes, you’d like to own only winners and dodge the losers. But you don’t have impeccable forecasting skills, nor does anyone else. So you need to own a basket of assets that aren’t all dependent on the same set of hopes and risks. You need to own asset classes that don’t move together so that some of your investments will go up when others stumble. At least that’s the theory.

While this may be cold comfort, the across-the-board meltdown we have been experiencing is rare. Asset classes tend to move independently for fundamental economic reasons. The primary risk to stocks is recession. But a recession typically means lower inflation and lower interest rates, which generally help bond prices. Likewise, international markets, commodities, and real estate have tended to ebb and flow at different paces.

Think back to the 2000-2002 technology implosion and market collapse. Asset allocation’s stabilizing powers kicked in then, as you can see in the chart below. Stocks took a beating, but the losses were offset by gains in REITs, commodities, and bonds.

Of course, it hasn’t worked that way in 2008-09, as the chart also illustrates. The real estate and credit crises have conspired to create a perfect storm that pushed virtually all asset classes — and all countries — down in tandem. But even in this period of high market stress, at least one asset class has gone against the grain: Treasuries. Last year medium-term U.S. Treasuries surged, with iShares Barclays 7-10 Year Treasury (IEF) generating a 17.9 percent total return. In times of great fear, investors run for safety. Owning government bonds is a hedge against chaos.

Time to Take Stock

Even in the best of times, what you’ll earn with a properly diversified portfolio is likely to look middling compared to the best-performing corners of the markets. To be properly diversified, you need to own assets that historically don’t earn as much as stocks do. Remember, during this historic bear market, Treasury bonds have delivered double-digit returns.

Therein lies one of the key lessons of diversification: It doesn’t mean you can safely overdose on stocks, as many investors undoubtedly did when the market was humming along. Consider how much protection bonds offer: For the 10 years through this past January, the Dow Jones Moderately Conservative Portfolio Index, a passively run global benchmark that’s rebalanced monthly and holds 40 percent stocks with the remainder in bonds and cash, posted a 3.9 percent annualized total return. Over the same period, the S&P 500 lost an annual 2.7 percent.

Allocation 2.0

Another lesson of the crash is that diversification is not a set-it-and-forget-it strategy. “What matters isn’t just how you diversify across asset classes,” says Adrian Cronje, director of asset allocation at Wilmington Trust. “It’s also how you rebalance your strategic allocation through time.” The basic rule: Favor asset classes that are paying you to assume extra risk, while pulling back in assets that can only pay off if everything works to perfection.

To know what you’re being paid to assume risk, look at how the asset class is valued. Take the dividend yield on stocks, generally defined as the past 12 months of dividends divided by the current price. A number of academic studies have shown that you can partially predict future stock returns by looking at measures of value such as the price-to-dividend yield.

Check out the chart below, which shows what you would have earned over the past 60 years if you had invested in the highest-yielding stocks. It’s not a perfect relationship by any means, but you’ll see that higher yields usually have led to higher returns 10 years out.

The recent dramatic increase in yield suggests that future stock market returns are looking more enticing. Indeed, the yield on stocks is higher than the yield on 10-year Treasury notes for the first time since 1958.

Valuation alone doesn’t explain everything. But it offers a valuable tool for thinking about the relative attractiveness of different investments. At the stock market peak of October 2007, REITs yielded just 4.2 percent, slightly below the 10-year note’s 4.5 percent. The question was, why buy REITs and assume the extra risk when you can earn a higher yield on risk-free Treasuries? The answer: Lighten up on REITs and favor Treasuries. Today, yields are suggesting the opposite. At the end of January, the REIT yield was a bit over 9 percent, a huge premium over the 10-year Treasury’s 2.5 percent.

What should a smart investor do?

You don’t want to repeat the overconfidence of the past years, nor do you want to replace it with the fear that is so rampant today. Start raising your portfolio’s exposure to stocks, REITs, and commodities, which are attractively priced. But remember that you don’t have perfect insight into the future, so you have to continue to diversify. Buy into attractive sectors slowly, and keep some cash at the ready for unexpected short-term price drops.

It’s now clear that until the recent market plunge you weren’t adequately paid to buy risky assets like stocks, REITs and commodities. Now you are.

James Picerno is editor of The Beta Investment Report.