For many investors, diversification meant investing across a wide array of investment styles or asset classes. Frequently some sort of optimization algorithm was utilized to maximize the trade-off between expected returns and expected risks. Lynchpin to this approach is the key role that correlation plays in the equation. The benefits of diversification are realized only if the investments truly behave differently from one another.
Unfortunately, many investors pursued “false diversification”, or a diversification strategy that involved simply ‘slicing and dicing’ the market.
One widely followed form of false diversification was to slice up the market into smaller and smaller pieces while neglecting to move the eggs out of the proverbial basket.
As the chart below displays, initially, investors divided equity markets into large cap and small cap “styles”. Next, a value and growth distinction was made. Eventually, the concepts of mid-cap and core were added to the style mix.
Splitting the hairs even further, concepts like mega-cap, micro-cap, “SMID”-cap, deep value, relative value, growth-at-a-reasonable-price, and momentum-growth were all incorporated into the concept of diversification. However, none of these styles were truly new assets: they were simply smaller slices of the same pie.
Real Portfolio Diversification Requires a Lack of Correlation
As noted above, true diversification is achieved when two or more investments exhibit different responses to market moves.
The table below shows how highly correlated all of these styles, or slices of the market pie, are to one another. Correlations between +0.80 and +0.90 are highlighted in yellow, between +0.90 and +0.95 in orange and above +0.95 in red.
No two styles have correlations less than +0.80, severely limiting the diversification potential of these investments.
See below for definitions of these Style Correlations
Investors with assets across each of these “styles” probably felt great when markets were going up and likely assumed diversification was working as advertised. But the simple and neglected truth was that if everything was going up at the same time, they would very likely all go down at the same time. And of course, that’s exactly what happened.
Even investors who moved into other asset classes like international stocks, emerging market stocks, high yield bonds, real estate, and commodities saw those investments plunge in lock-step with their US equity investments during the 2008 crisis. When portfolio diversification was needed most, the correlations spiked. The two tables below display how correlations shifted from their long-term averages during the crisis of 2008:
The dampening of a portfolio’s overall volatility is only possible if the constituents of a portfolio have low or, ideally, negative correlations. In a follow-up blog post, we will explore the mathematical underpinnings of correlation. Suffice it to say, a well-constructed diversification strategy should have losses in one portion of the portfolio offset by gains in another.