Questions about the benefits of portfolio diversification came to light after 4th quarter of 2008. This is the time when Lehman Brothers went bust and panic was the cloud hanging over financial markets worldwide. This is when pretty much every asset class went to a correlation of 1. In other words, there was no place to hide as most investments went down and diversification did not help much. However, I believe there are a couple of things we need to keep in mind.
1. This was the time of panic and could be considered irrational behavior. This does not happen every day, month or every year.
2. Those suggesting that diversification was dead at that time perhaps are not 100% accurate. If you had exposure to USD or US treasuries or Money Markets (outside of the one that went below $1) you would not have experienced the same amount of losses. If you still experienced losses similar to those experienced by financial markets perhaps that means that you did not have meaningful exposure to asset classes mentioned above and therefore did not have a true diversified portfolio.
That is correct, bullet-proof diversification is hard to achieve. One of the main reasons for that is the fact that there are many different asset classes, sectors, etc. Diversification is needed to help your investment portfolio combat volatility and as the point 1 above suggests ‘panic’ does not happen very often. Therefore, I would suggest picking out a few very important asset classes for your risk profile and objectives, and start from there.
One thing I would like to mention and this is a very common diversification ‘mistake’, having 10 technology stocks is not diversification. It is a diversification of the technology sector, but not the diversification that one should have for the overall portfolio.
As mentioned above, one of the benefits of diversification is potentially lower volatility. However, it is also worth mentioning that diversified portfolios may provide lower returns. As an example let’s say that stocks went up 100% and bonds were flat for the year. If investor held stocks only, there would be 100% profit. If investor had a diversified portfolio of 50% in bonds and 50% in stocks, then the overall performance of the portfolio would be only 50%. You might be thinking about taking much more risk right about now, BUT remember that it could be the other way around. One asset class can actually go down and existence of the other may prevent you from losing your shirt. Therefore, chose wisely which road you would like to take, but I will continue to use diversification. I will d so because I would rather have 8-10% annual return on the consistent basis as opposed to enjoying 50% spike one year and then watch my profits disappear the following year, when the tide turns.