Wednesday, October 8, 2008

Diversification: Why is it not working?

It is  a core belief in finance that investors should diversify. Whether they should diversify across all stocks or a few is what is debated, and what you think about the efficiency of markets or lack thereof determines which side of the debate you will come down on. If you are a believer in efficient markets, you would have spread your money across index funds investing globally. If you believe that markets systematically misprice classes of securities (and realize their mistakes later), you would still diversify across these securities (low PE stocks, beaten down stocks etc.)
This market has tested the core belief in diversification. Even the most diversified investor in the universe would have lost a big chunk of his or her portfolio over the last 3 weeks. Why has this happened and why is diversification not paying off like it was supposed to? The answer lies in the fact that we have sold investors too well on the "diversification" idea. Twenty years ago, when the sales pitch for adding international stocks and real estate to portfolios was made, the gains seemed obvious. Equity markets in different countries were not highly correlated; what happened in Turkey had little impact on what happened in Brazil. Having stocks in both markets therefore dampened risk in the portfolio. Real estate seemed to move in directions unrelated to equities, thus making a portfolio composed of the two asset classes less risky. As investors(individuals, private equity funds, hedge funds) diversified across markets and asset classes, there are two things that have happened:
1. The correlation across equity markets has risen dramatically. A crisis in one emerging market seems to spill over into other emerging markets. A crisis in a developed market spills over across the world. As market moves mirror each other, having your money spread out across markets has a much smaller diversification benefit than it used to.
2. Securitizing real estate and bringing it into portfolios has made risk in the real estate market more closely tied to the overall equity market. Diversifying across asset classes has a much smaller impact.
Don't get me wrong. I think that not diversifying is a deadly mistake for most investors, and I am still firm believer in diversification. However, we need to temper the sales pitch. Diversifying can create benefits for investors, but those benefits are much smaller in the global market place that we are now.


Dennis Chiuten said...

I find it ironic that we're witnessing this increased correlation across markets and asset classes after all the (apparently disproven) talk about other developed economies decoupling from the U.S. economies. Given the interconnectedness of global markets, do you think decoupling will ever be realized?

Aswath Damodaran said...

You cannot have your cake and eat it too. Much of the growth in India and China has come precisely because they decided to put decades of ideology behind and joined the global economy. You cannot selectively decouple from that economy, when things are going badly.

WebMoney said...

From an American perspective, the markets are interconnected only to the extent that the dollar maintains its status quo as a reserve currency. The US financial market boom we witnessed during the last eight years was largelly a result of obscure derivative instruments' ability to absorb and consequently attract the world's excess Eurodollars (including sovereign and institutional reserves of China, India, Japan, etc.). Having failed the global investor community, US has no choice but to relinquish its financial and monetary dominance. That would be pretty close to a decoupling of global financial markets - from an American perspective.
As far as the current volatility on foreign markets is concerned, we are seeing diversified investors decreasing their foreign portfolios to shore-up cash in order to cover their losses in US.

imtiaz said...

Dear sir Damodaran,

Dont you think that the diversification is good in efficient market case but one should be cautious if the markets are not efficient?

imtiaz said...

Dear Sir Damodaran,

It is in repose to your profile message.When you say saomething we listen it very very carefully.

Thanks for sahring worthy Ideas

Aswath Damodaran said...

Diversification is a good rule to follow, whether you believe that markets are efficient or not. In efficient markets, you may choose to diversify indiscriminately (the proverbial monkey throwing darts at the dartboard). In inefficient markets, you diversify across assets that you believe that the market is systematically undervaluing (small companies, boring companies etc.)