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By Rachel Haig | 12-10-2009 11:00 AM

Did Diversification Fail?

Peng Chen, president of Morningstar's Ibbotson Associates, says diversification is able to mitigate, but not eliminate, risk.

Rachel Haig: I'm Rachel Haig for Morningstar.com. I'm here with Peng Chen, president of Ibbotson Associates. Ibbotson Associates recently conducted a study of diversification in 2008. Thanks for joining me, Peng.

Peng Chen: No problem. Thanks, Rachel. Thanks for having me here.

Haig: So what did we see with diversification in 2008? Did it work?

Chen: Well, we actually got a lot of questions on that, and given the market downturn. So we actually did a deeper dive and really looked at diversification and, really, modern portfolio theory in general.

And so the quick synopsis of that is that the number-one thing people really need to remember is that while there's diversification, or the modern portfolio theory, it's not a process that eliminates risk. It helps you mitigate risk. And so what happened in 2008 is really a system-wide risk, and diversification actually worked for the most part.

I can give you some evidence. First of all, if you talk about diversification, you really want to look at the security-level diversification. And if you look at how diversified portfolios have done--for example, mutual funds versus individual equities--diversified portfolios across the board have done much better compared to individual securities. And so we know, in the basic form of security level, diversification worked.

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