Why diversification isn't dead

(MoneyWatch) Ever since the financial crisis, when the correlation of all risky assets rose towards one, investors have been hearing that globalization has caused the world to become flat and the benefits of diversification to disappear. It's a refrain that I hear repeatedly from the media, as well as from investors concerned about their portfolios. To paraphrase Mark Twain, the rumors of the death of the benefits of diversification have been greatly exaggerated. What's so surprising is that the evidence is right in front of you.

To demonstrate that there are still significant benefits to diversification, consider the returns of the past several years of the various funds of Dimensional Fund Advisors, when diversification supposedly wasn't working because correlations had risen.

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In 2009, while its U.S. large company fund returned 27 percent, it was outperformed by DFA's emerging markets, emerging markets value and emerging markets small fund by 42 percent, 65 percent and 72 percent, respectively. In addition, its international large value and international REIT funds outperformed their domestic counterparts by 10 percent and 8 percent, respectively.

In 2010, while its U.S. large company fund returned 15 percent, it was outperformed by the three emerging market funds from 6.8 percent to as much as 15.2 percent. On the other hand, the U.S. large, large value, small, small value and REIT funds outperformed their international counterparts by 5.7 percent, 9.6 percent, 6.8 percent, 12.8 percent and 10.6 percent.

In 2011, its U.S. large, large value, small, small value and real estate funds outperformed their international equivalents by 14.4 percent, 19.8 percent, 12.2 percent, 20.8 percent and 7.2 percent, respectively. Its U.S. large company outperformed its emerging markets, emerging markets small and emerging markets value funds by 19.5 percent, 24.7 percent and 27.7 percent, respectively. If diversification wasn't working, we wouldn't have such wide dispersions in returns.

In 2012, the relative performance of U.S. and international funds reversed with international funds outperforming their U.S. counterparts in every case. And while we didn't see as wide a dispersion of returns, there were still large differences. For example, DFA's international REIT fund outperformed the US REIT fund by 15.9 percent, and the three emerging markets funds outperformed the US large fund by from 3.4 percent to as much as 8.6 percent.

In 2013, through Friday the relative performances once again reversed, with the U.S. funds outperforming their international counterparts in every case. Their U.S. large, large value, small, small value and REIT funds outperformed by 6.4 percent, 11.0 percent, 4.9 percent, 5.1 percent and 2.9 percent, respectively. And the U.S. large fund outperformed the three emerging market funds by from 8.6 percent to as much as 13.3 percent.

While it's true that correlations have been rising, diversification across asset classes is still working quite well, at least for those who have the discipline to stay the course and rebalance. The bottom line is that far too many investors took the wrong lesson -- diversification across risky assets doesn't work any longer -- from what happened during the financial crisis when correlations of all risky assets rose toward one. The right lesson was that the most important diversification is to high quality fixed income, making sure your allocation is high enough to dampen the risk of your overall portfolio to an acceptable level.

While the correlations of all risky assets will likely rise toward one when we have the next crisis, the correlation of the safest fixed income investments is likely to fall. For example, for the period 1926-2012, the annual correlation of the S&P 500 Index to long-term Treasury bonds was 0.01. However, from 2000 through 2012, when the correlation of risky equities were rising, the correlation of long-term Treasuries to the S&P 500 fell to a -0.71. This explains why making sure that your portfolio has a sufficient allocation to the highest quality fixed income assets is the most important diversification of all. This point can't be emphasized enough.

Image courtesy of taxbrackets.org.