Deworsification…Caveat Emptor If You Seek to Minimize Losses Through Diversifiers Alone

Note: This article appears on the Strategist Channel

By David Haviland

One of the key tenets of Modern Portfolio Theory (MPT) is the ability to diversify a portfolio among varying asset classes in an attempt to realize a higher return and lower volatility than the average portfolio investment. In theory, diversification provides the one “free lunch” available to investors; more return for less risk.

While the goal is noble, recent history has shown that supposed diversification can be a fool’s errand. During extended periods of market failure…true bear markets, the correlation between risk assets begins to move towards one. This increased correlation completely negates the benefits of diversification, and has many ramifications for our industry.  As new products are created and portfolio construction includes more and more “diversifiers”, those relying solely on this alleged diversification to protect against large portfolio losses may be sorely disappointed. Caveat emptor!

Related: Bonds Have Bear Markets Too, Remember?

Risk assets are just that, risky! The further an investor ventures away from large, liquid markets, the more unforeseen risk is taken on by a portfolio.  As the chart below shows, when global stock markets endured their bear market in 2007-2009, varying geography, market capitalization and specific industry selection offered little protection against major losses. In fact, many of these “diversifiers” against portfolio risk had larger drawdowns than the S&P 500® Index!


Since the majority of bonds have enjoyed a general decline in interest rates since the macro interest cycle peaked in 1981, you must go back a few decades to see how they responded to rising interest rates and their own bear markets. The exception is high yield or junk bonds which experienced their largest drawdown in the 2007-09 bear market, when the IBoxx Liquid High Yield Index fell 32.87%!

The reasons for these large drawdowns are vary. Ours is now a global economy. If a bear market starts in one corner of the globe, it is rare that the rest of the world does not follow suit.   Getting more specific, some asset classes simply are not as liquid as broad equity markets and buyers disappear when they are needed most.