January 05, 2009

Diversification and Varieties of Risk Management

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:

"Diversification is supposed to work, so that not everything goes down by the same amount. It didn't work (in 2008). If you were diversified or not, it didn't matter," says Jennifer Ellison, a principal with San Francisco money management firm Bingham, Osborn & Scarborough.

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.

Source

Kathleen Pender, "Investors ask: Where did all that money go?" San Francisco Chronicle, January 1, 2009

Jan 5, 2009 2:44:25 PM | Language, Markets, Money Management, Mutual Funds, Personal Finance

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