A few days ago, I was having lunch with an acquaintance when he made a remark that went something like this: when the markets were experiencing a sell-off in the weeks before, I saw that almost everything went down: shares, bonds, REITs, gold, etc. I thought diversification is supposed to protect us in all market conditions but somehow this is not true. Is diversification dead?
This is a very good question, and I believe most of you would ask the same thing during that moment. As a proponent of diversification, it is in my interest (and all of ours) to address it.
There are two explanations: for the first one, I shall use a paper which one of the authors is the father of modern portfolio theory (MPT), Harry Markowitz. The second one is based on my observations and hypothesis with regards to the market.
#1: Does Portfolio Theory Work During Financial Crises?
This was the title of the paper written by Markowitz and two other authors (link under References below). It acknowledged that during financial crises, all asset classes go down and all correlations go up, but it also stated that this was predicted by portfolio theory and why we should use MPT.
Using William Sharpe’s (the inventor of the famous Sharpe Ratio) model, securities are correlated with one another because on the whole, all are correlated with the market. This brings us to the idea of market risk, or systematic risk, which cannot be diversified away. In times of crises, when the market goes down, all would go down with it.
To visualize this better, below is the formula of Sharpe’s model:
Return of a security = alpha of the security + (beta of the security x return of the market) + idiosyncratic random term
With a market downturn, the return of the market goes down, thus pulling down the return of the security as well. The saving grace comes in two forms: the numbers of the security’s beta (the volatility of returns with respect to the market) and the idiosyncratic random term (dubbed as unsystematic risk, which could be diversified away) and these could help to limit the fall.
The above is the main gist of the paper, which went on to state that it is good to diversify across and within asset classes, and of course the adage of “Don’t put all your eggs in one basket”.
#2: The Bedokian’s Hypothesis
If #1 is too theoretical for you, then probably my hypothesis (sorry, no paper) would give another dimension of explanation.
Coming from a behavioural aspect, an investor or trader would move his/her capital to a security that would bring better returns (“more bang for the buck”) and/or to a perceived safe haven of the moment. This explains why typically when equities/REITs go down, the next go-to would be bonds and/or commodities, and when the bull market returns, the monies would flow back to equities/REITs.
In the event of a down market, usually investors and traders would want to preserve their capital first and contemplate their next move, therefore liquidity takes priority and the next best thing would be to sell whatever they have on hand. This results in why almost every asset class is negatively affected. It would take some time for them to select what their next moves are and redeploy their capital.
And that is not all. Depending on the prevailing economic condition, the frequency of shifting of capital between asset classes varies with each market participant; some would just rebalance their portfolios accordingly, while others would continue to move the capital across that best suit the moment. The latter could probably explain why some investors moved to long term bonds during the market sell-off1, even though the prospect of higher interest rates looming across the horizon.
It is easy to conclude that diversification has no use in times of a market downturn, but over time it has still proven itself to be the one valuable tool in protecting your portfolio over the long period. Bear markets, while painful to go through, were historically shorter than bull’s, and such periods would be viewed as kinks (and opportunities) as you look back in time.
So, is diversification dead?
Long live diversification!
Markowitz, Harry M.; Hebner, Mark T. and Brunson, Mary E. Does Portfolio Theory Work During Financial Crises? https://www.ifa.com/pdfs/does-portfolio-theory-work-during-financial-crises.pdf (accessed 25 Jun 2022)
1 – Min, Sarah and McKeever, Vicky. Treasury yields fall, prices climb as investors seek shelter from stock sell-off. CNBC. 19 May 2022. https://www.cnbc.com/2022/05/19/us-bonds-treasury-prices-climb-following-stock-market-sell-off.html (accessed 25 Jun 2022)