Although there may be a wider selection of asset classes to invest in today, wise investors have been benefiting from the concept of diversification, roughly described in the featured quote from the Talmud, for more than 2000 years. To spread out an investor's capital among multiple asset classes (stocks, bonds, real estate, commodities, and cash for instance) is to take advantage of the risk/return trade-off that diversification offers within the total portfolio.
The sustained level of volatility that the markets have been exhibiting over the last couple of months has been testing the utility of this important concept. Fortunately, unlike the steep market sell-off of the equity markets in 2008 - 2009 when US treasury bonds were the only asset class to post a positive return, not all asset classes have been highly correlated of late.
From the chart below, you can see that U.S. and international equities (as represented by the Russell 3000 Index and the MSCI EAFE Index, respectively) have dropped year-to-date (through September 13). However, bonds and REITs have posted moderate to strong positive results over the same period. Commodities, while significantly outperforming equities, have a slightly negative year-to-date return.
Didn't the media declare that the value of diversification was dead? What is different today from the high volatility experienced in 2008 and ultimate collapse of asset prices in March 2009? Our opinion is that the experience of 2008/2009 was an exception to the rule, not the new rule.
We believe that the steep market selloff of the second half of 2008 was driven less by fears of a prolonged recession and more by a lack of liquidity. In 2008, when Lehman Brothers failed, credit markets worldwide froze. Additionally, toxic assets held by large financial sector firms were being written down to zero, and panic ensued. This panic lead to a massive global dumping of assets across the board. For a short period of time, the concept of diversification did prove ineffective because all asset classes depend upon a functioning credit/financial system. Today, the credibility of that system has been restored.
Currently, while justifiable fears abound regarding the European sovereign debt situation and the softening of the U.S. economy, there has been no all-encompassing delinking of asset prices from their fundamental intrinsic value. Prospective cash flows from corporate bonds, real estate, and some pockets of the stock market have investors believing that these asset classes are now worth buying and holding. Even if the next couple of quarters feature weak, but positive, economic growth, the strong balance sheets of U.S. stocks along with decent corporate earnings could provide the basis for at least a moderate rebound in stock prices.
It is axiomatic that the media tends to focus on bad news. When stock prices plunge, the headlines announce it. What well-diversified investors know, however, is that the headlines do not always tell the whole story.