Ben Inker: "When Diversification Failed"

After citing his work on Monday, we spent some time reading Ben Inker's recent white paper on diversification, portfolio design, and asset class valuation. This is very good stuff, a timely reminder that valuation determines medium- and long-term investment returns--and that diversification across risky asset classes won't do much to limit losses when most or all of those risky asset classes had become similarly overvalued. (We riffed on this topic back in January.)

There's much more in this paper than we can cite here, so please register at GMO.com and read the whole thing. But here's a very telling paragraph (emphasis added in bold):

Before getting into the lessons to be learned from the recent past, we should recognize that once the world was in the situation it was in by the summer of 2007, there was no way that portfolio construction techniques could have reduced the size of the overall losses. In 2007, the world saw the most profound bubble in risk assets ever seen, and it is the bursting of this bubble that has led to the enormous loss of wealth we have experienced to date. While we can try to second guess the government policy decisions that have brought us to where we are today, the truth is that most of the money lost in the last 18 months has simply come from overvalued asset classes reverting to the mean. A single institution could have avoided the fall by selling out of all of their risk assets, but if every institution had tried, they would have simply succeeded in hastening the collapse. The world in general is long risk assets. An individual investor selling out or even going short risk only serves to redistribute the losses; he does not reduce them. The only way to have avoided the aggregate pain would have been to have avoided the bubble in the first place, which would have involved changing the way portfolios were invested in the period between 2000 and 2006.

Here and elsewhere, the key variable is the price one pays to acquire a financial asset. In 2007, risky assets were all expensive. And the rest is recent history.

There's more, in particular the ways in which diversification across (and, implicitly, within) asset classes plays out over varying time horizons.

If you crave sentences such as "The period from 2003-07 was probably the Golden Age of the covariance view of risk for institutional investors," this is the paper for you. Speaking for ourselves, we do, and it is.

Source

Ben Inker, "When Diversification Failed," Grantham Mayo Van Otterloo & Co., December, 2008 (registration required)