Is the Promise of Portfolio Diversification Dead?
By Citi Global Wealth Management

The severe downturn in financial markets since 2007 has led many investors to question the benefits of portfolio diversification. Some are reevaluating their strategies, reassessing their risk tolerance and rethinking their financial plans. Is the promise of portfolio diversification dead? We think not.


BENEFITS OF DIVERSIFICATION
Asset allocation theory states that by building a portfolio of different asset classes, investors can achieve greater portfolio efficiency, or a higher return per unit of risk. For stocks, we use the Standard & Poor's 500; for bonds, the Ibbotson Intermediate Government Bond Index or the Ibbotson Long-Term Corporate Bond Index. From 1926 through February 2009, the average annual returns were 9.3%, 5.4% and 5.7%, respectively.

Now consider portfolios split 50/50 between the S&P 500 and intermediate government bonds or the S&P 500 and long-term corporate bonds. To measure the efficiency of their risk-adjusted total returns, we use the Sharpe ratio. This calculation starts with the portfolio return, subtracts the risk-free rate and divides the remainder by the standard deviation of returns, a proxy for volatility.

With this metric, the higher the ratio, the more efficient the portfolio. For the period from 1926 to the present, a portfolio of US stocks alone had a Sharpe ratio of 0.29. The ratio was 0.39 for the portfolio blending stocks and corporate bonds and 0.41 for the portfolio with government bonds. So, while an all-equity portfolio had a higher nominal return, the portfolios that were half bonds provided a higher return, given the amount of risk.

ATTRIBUTING THE BENEFITS
Importantly, the blended portfolios’ improved efficiency relative to an equity-only portfolio was not due to bonds themselves being more efficient than stocks. Rather, the blended portfolios were more efficient because stock and bond returns do not always move in tandem. In other words, more often than not they complement each other.

In addition, if you look at the returns across rolling 10-year periods, the mixed portfolios delivered positive returns 100% of the time versus 96% for the all-stock example. Moreover, the blended portfolios beat inflation 87% of the time, a big improvement compared with bonds alone.

MORE EFFICIENCY
A study of the 10 most severe equity bear markets since 1926 shows the value of portfolio diversification (see table below). During these downturns, the S&P 500 Index posted an average minus 35% return. The blends fared better, with average returns of minus 19% for portfolios using long-term corporate bonds and minus 17% for those using intermediate-term government bonds.

By the time the 100% equity portfolios recovered lost ground and returned to their prior cycle peaks, the blended portfolios stood, on average, 21% and 17% above their pre-correction highs for portfolios using corporate bonds and government bonds, respectively. In each instance, the blends performed better than portfolios using equities alone during the entirety of the equity bear market and recovery periods.




PERFECT CORRELATION
During shorter-term periods of market distress, it is not unusual for the correlations among asset classes to move toward 1.0, perfect positive correlation. During these periods, investors are often forced to sell what they can, not what they prefer.

The latest episode has been no exception. Even so, diversified portfolios helped to contain the damage. From Oct. 7, 2007, the last high on the S&P 500, until Feb. 27, 2007, the S&P 500 fell 51.4%. A portfolio of half S&P 500 and half Barclays Capital US Aggregate Index, which includes government and corporate bonds, lost 22.2%. A portfolio of 50% S&P 500, 40% Barclays US Aggregate and 10% cash was down 16.7%.

Although simplified, these results indicate that broad portfolio diversification matters. The fact that even the portfolios with bonds and cash registered negative results underscores how difficult the market environment has been. Essentially, only plain-vanilla government securities earned positive returns during this period. But such episodes of severely strained liquidity, while not unprecedented, are highly unusual and should not be considered the new norm.

INFLATION HEDGE
While US equity returns can fluctuate wildly in the short run, over longer periods, they tend to be positive both before and after inflation. Since 1926, S&P 500 returns have topped inflation in 68% of the one-year periods, 77% of the five-year periods, 87% of the 10-year periods and 100% of the 20-year periods. Earnings and the economy both tend to grow faster than inflation, which provides an inflation hedge for long-term investors.

Nonetheless, recent events may have made some investors realize that their tolerance for owning equities is not as high as they thought. In that case, it is time for them to reassess their risk profiles and strategic asset allocations. Still, with the bear market well advanced, this is perhaps not the most opportune time to move away from stocks. Besides missing a potential recovery in stocks, an investor risks overloading his or her portfolio with low-return assets.

There is another problem with moving too heavily toward bonds: They are less likely than stocks to beat inflation. Across rolling 20-year periods since 1926, the real or inflation adjusted return has been positive 100% of the time for stocks but only 73% of the time for intermediate-term government bonds and 59% for long-term corporate bonds. These data explain the importance equities play for long-term investors who seek to beat inflation and, therefore, achieve greater purchasing power in the future for themselves, their heirs or their philanthropic interests.

MISMANAGED EXPECTATIONS
To be sure, some investors and media pundits have interpreted recent investment results as a failure of portfolio diversification to deliver on its promise. As we see it, the failure has been in managing investors’ expectations and over-promising on what portfolio diversification can do.

Its benefits are well grounded, but investors should not expect to be immune from the effects of a severe bear market. When most asset classes are declining, a portfolio will not increase in value because it is well diversified; only well-timed tactical asset allocation adjustments and other temporary hedging strategies can do that.

Fortunately, today's harsh conditions are the exception rather than the norm. Portfolio diversification remains the best way to balance risk and return over long investment horizons.

________________________________________________________________________________________

ABOUT THE AUTHORS
Jeff Applegate is the Chief Investment Officer (CIO) of Citi Global Wealth Management. Charles Reinhard is a Senior Investment Strategies; Nicolas Richard, Director of Strategic Asset Allocation and Douglas Schindewolf, Director of Tactical Asset Allocation of Citi Global Wealth Management.

Important: Opinions expressed herein should be regarded solely as general market commentary, and may change without prior notice. Past performance is no guarantee of future results. This column was first published in Citi Private Bank's publication The View in April 2009.