Does Diversification Still Work?

You followed the rules. You put together a diversified investment portfolio as we—and other financial experts—recommend. Despite that, your portfolio went down along with the rest of the market. Why didn't diversification work?

While it may not seem like it, diversification did work. You probably would have lost much more if you hadn't diversified. We'll show you why you shouldn't give up on diversification and why it is still effective.

It helps to know a little bit more about what affects diversification. At the heart of it is "correlation." Simply put, correlation is a measure of how the returns of two investments move together, i.e., whether their returns move in the same or opposite direction and how often. Correlation is a number from –100% to 100% that is computed using historical returns. A correlation of 50% between two stocks, for example, means that in the past when the return on one stock was going up, then about 50% of the time the return on the other stock was going up, too. A correlation of –70% tells you that historically 70% of the time they were moving in opposite directions—one stock was going up and the other was going down.

Correlations can change dramatically and rapidly in volatile markets. Assets can become highly correlated, meaning their returns move in the same direction. This reduces the short-term benefit of diversification, which is what happened recently.

A deeper look at recent markets
The correlations of U.S. stocks to several other types of investments increased during the 2008–2009 bear market. As the chart below shows, the correlations of U.S. stocks to international stocks and high-yield bonds jumped to nearly 90%. Investment-grade bonds and cash went from being negatively correlated to U.S. stocks to being positively correlated. All of this reduced the effectiveness of diversification during this period.

Source: Fidelity Investments. Historical average 12-month rolling correlations for the 10-year period ending in August 2008 are compared with the same for the period from September 2008 through February 2009. Rolling correlations are computed by moving the 12-month window by a month each time. U.S. equities, developed world stocks, emerging market stocks, U.S. investment-grade bonds, U.S. high-yield bonds, U.S. real estate securities, and U.S. cash and commodities are represented by the total returns of the Dow Jones Wilshire 5000, MSCI EAFE, MSCI Emerging Market Stock, Barclays Capital U.S. Aggregate Bond, FTSE REIT, U.S. 30-Day Treasury Bill, and Dow Jones-AIG Commodity Indexes, respectively.

These changes in correlation aren't surprising—it's happened before. For instance, in the 2002 dot-com bear market, correlations increased dramatically. Compared with the previous 10 years, correlations of U.S. equities to developed world stocks, emerging market stocks, and U.S. high-yield bonds went up from 55%, 61%, and 35% to 85%, 84%, and 56%, respectively.¹

What's different about the recent market decline is the increase in volatility in the markets. During the 2002 dot-com decline, volatility spiked, but not as high as last year. The recent bear market's volatility coupled with increased correlations has heightened the impact on investors' portfolios.

Diversification has not failed
While it may feel like diversification has failed in recent months, it hasn't. The major asset classes are not perfectly correlated, only more highly correlated. There's a difference—it means that diversification still helped contain portfolio losses, only the benefit was lower than before the market decline.

Consider the performance of three hypothetical portfolios: a diversified portfolio of 70% stocks, 25% bonds, and 5% short-term investments; a 100% stock portfolio; and an all-cash portfolio.

 
Source: Fidelity Strategic Advisers, Inc. Hypothetical value of assets held in untaxed accounts of $100,000 invested in a portfolio of 70% stocks, 25% bonds, and 5% short-term investments and 100% stocks, respectively. This chart's hypothetical illustration uses historical monthly performance from January 2008 through March 2009 from Morningstar/Ibbotson Associates: stocks, bonds, and short-term investments are represented by the DJ Wilshire 5000 Index, Barclays Capital Global Aggregate Bond Index, and U.S. 30-day T-Bills, respectively. The chart is for illustrative purposes only and is not indicative of any investment. Past performance is no guarantee of future results.

By the end of February 2009, both the all-stock and diversified portfolios would have declined. The all-stock portfolio would have lost nearly half of its initial value (–48.2%), however, while the diversified portfolio would have lost just over a third (–33.9%). Yes, the diversified portfolio would have declined, but diversification would have helped reduce losses compared with the all-stock portfolio. The all-cash portfolio (0.02%) would have outperformed the all-stock and diversified portfolios over this 14-month period. While short-term investments performed well last year compared with stocks, investing in all cash limits the future growth opportunities of a portfolio, so it is not an effective long-term strategy.

Now let's look at March and April 2009. Our hypothetical all-stock portfolio would have risen by 19.2%, the diversified portfolio by 11.7%, and the all-cash by 0.03%. This is a good example of how such portfolios can behave in rising markets. If the market continues its upward trend, the diversified portfolio may gain less than the all-stock portfolio and more than the all-cash portfolio. This is what diversification is about. It will not maximize gains in rising markets, but it can help limit losses when the market is turning down.

How to build a diversified portfolio
To start, you need to make sure your investment mix (e.g., stocks, bonds, and short-term investments) is aligned to your investment time frame, financial needs, and comfort with volatility. Next, when building a diversified portfolio, you want to choose investments whose returns are not likely to move in the same direction, and, ideally, those that move in the opposite direction, i.e., highly negatively correlated. This way, even if a portion of your portfolio is declining, the rest of your portfolio may still be growing. In turn, the overall impact of poor market performance on your portfolio can be dampened. We can help you determine an appropriate asset allocation and plan for your investment needs.

In conclusion
Diversification didn't fail in the recent market downturn. It worked—just to a lesser degree. It's important to remember that diversification can only help reduce portfolio risk, not eliminate it.

Let Fidelity help you find an appropriate investment mix with Fidelity Portfolio Review.²

Or consider having Fidelity professionals manage your investments with Fidelity Portfolio Advisory Service^{® 3}

(Tell us what you think about this article. E-mail comments to Fidelity.Investments@fidelity.com.)

Past performance is no guarantee of future results.

Asset allocation and diversification do not ensure a profit or guarantee against loss.

Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk.

Investing involves risk, including risk of loss. Generally, among asset classes, stocks are more volatile than bonds or short-term instruments.

1. Average 12-month rolling correlations for the periods from January 1991 to December 2000 and January 2001 to December 2002. Rolling correlations are computed by moving the 12-month window by a month each time.

2. Portfolio Review is an educational tool.

3. Fidelity Portfolio Advisory Service^® is a service of Strategic Advisers, Inc., a registered investment adviser and a Fidelity Investments company. This service provides discretionary money management for a fee.