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Did Diversification Fail?

Rachel Haig

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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The second-level diversification we look at is really the basic asset-class-level diversification, which typically involves stocks, bonds, and cash--these three basic types of asset classes. And if you look at it from that perspective, although stock went down quite a bit in 2008 and early 2009, both cash and bonds held up reasonably well.

So if you are an investor investing in a diversified portfolio that consists of stocks, bonds, and cash, you actually did a lot better compared to just investing in stocks. So diversification on the basic asset-class level also worked.

What didn't work, probably a lot of people realize, is that most of the asset classes, especially those asset classes that have any risk exposure to the stock market, went down together with the stock market. And that's really a symptom of systematic risk, in our mind.

And so, to come back to what I talked about opening up, diversification, at the end of the day, really helps you diversify unsystematic risk and idiosyncratic risk. So what happened in 2008 is mostly a systematic risk event that no wonder most of the asset class that has market-risk exposure went down.

Haig: So, in 2008, it sounds like, on the basic level, asset allocation definitely worked between stocks and bonds and cash.

Chen: That's right.

Haig: But diversifying regionally, for instance with international stocks, didn't really help.

Chen: Did not.

Haig: OK. Do you expect the same thing to hold true going forward, or do you think that was unique to 2008?

Chen: Well, I think there was certainly a lot of uniqueness to 2008, and that was probably the second time in history that the entire global financial system was challenged. And so, hopefully, we're not going to see that very often. But that's the unique aspect of it.

But certainly, the not-so-unique aspect, you definitely need to realize that the diversification benefit, especially among equities across different regions, are diminishing, because of globalization in terms of the economy as well as the globalization in terms of the financial market, money flows, tradings, and so forth.

So we expect diversification benefit to continue to diminish across global equity market. But for the traditional bonds, cash, and stock, we still very much believe diversification will be there and will be there for a long time, because those are fundamentally very different instruments.

Haig: Thanks for sharing the results of the study with us.

Chen: No problem.

Haig: For Morningstar.com, I'm Rachel Haig.