Kathleen Pender published an interesting piece in the New Year's Day edition of the San Francisco Chronicle. Pender's basic question is this: What good is diversification when pretty much everything lost value (and with relatively high correlations) in 2008?
Asking that question suggests a subtle-but-important misunderstanding of portfolio design and expectations thereof. Throwing volatile asset classes together (say, U.S. stocks, EAFE stocks, and BRIC stocks) can help smooth a portfolio's trajectory (as it did in the first years of this decade, when non-U.S. equities outperformed), but that smoothing is hardly a sure thing.
The fact is, sensibly risk-averse investors (as opposed to those who have become risk-averse* only in the aftermath of the last 18 months) can/should/must reduce expected short-term risk by adding high-quality fixed-income (i.e., treasuries notes and bonds) and cash-equivalents (i.e., treasury bills) to their portfolios. As it happens, those asset classes did hold up last year, which makes this passage from Pender's piece a little mystifying:
If asset managers and investors allowed themselves to believe that small-cap and non-U.S. equities provided some sort of safe haven...well, let's just say they earned last year's nasty bear market.
Some say diversification is the only free lunch in investing.** There's some truth to that. But when it comes to diversifying across asset classes with an eye to reducing volatility, the only way to make a meaningful dent in expected short-term risk is to reduce one's exposure to equities and equity-like assets. And the time to do that, for the vast majority of investors, passed by several months ago.
* In a perfect world, we'd never see "adverse" used where averse belongs. Alas, that's a world we're unlikely to experience.
** In a former life, we copped a few actual free lunches courtesy of the Wall Street selling machine, but that's another matter entirely.
Kathleen Pender, "Investors ask: Where did all that money go?" San Francisco Chronicle, January 1, 2009