Does Diversification Really Work?
Diversification
Investors have been indoctrinated to believe that diversification is unequivocally good, and that it lowers risk. You might ask, what risk are we lowering? And does diversification help when you need it most? This paper will attempt to explain what the risk is that diversification really lowers, and whether it helps during large market drawdowns, i.e., when you need it most.
A Stock Market Investor
Assume that an investor owns a stock portfolio that tracks the S&P 500 Index, a diversified index of the largest five hundred publicly traded stocks in the US, and generally considered to be “The Market”. During a short one-month period from February 19th through March 23rd of 2020 (The Covid Drawdown) the S&P 500 Index decreased almost 34%. There were only six companies that had positive returns. All the other members were down. The brief list of equities with positive returns includes three pharmaceuticals’ companies, a pizza delivery company, and a company that makes bleach, among other products:
(Source: Bloomberg)
An unsuspecting investor that responsibly diversified their equity portfolio could be excused for being shocked at the level of decline. Perhaps, if the investor added even more equity diversification the results would have been better. Our investor could have owned an equity portfolio that tracked the Wilshire 5000 Index (W5000 Index), which holds over 5,000 US based stocks. Alternatively, our investor could have expanded beyond US based companies and owned a portfolio that tracked the MSCI All Country World Index (MXWO Index), which currently has over 1,500 holdings. This would have expanded the number of holdings from 500 to 5,000, or from 500 to 1,500 plus global diversification from countries and currencies. Surprisingly, instead of reducing the maximum drawdown the results would have been slightly worse than the return on the S&P 500 Index:
(Source: Bloomberg)
These three Indices, the S&P 500, the Wilshire 5,000, and the MSCI All Country World Index, are all considered to be ‘diversified’. So, what happened? During this period (The Covid Drawdown) stock price returns were completely dominated by market risk. Broad based equity diversification was ineffective.
Market wide declines usually result from some unexpected event. In this instance market risk manifested in the form of a once in a hundred-year (hopefully) Pandemic. The Pandemic was an exogenous shock to the global economy. In markets, fear overtook greed. If market risk can completely overwhelm the diversification within an asset class, like it did to these three equity indices, then we need a more nuanced understanding of risk.
Breaking Down Risk
Let us examine the equity (stock) asset class. Risk can be broken down into two distinct sources:
1. Systematic (market) risk
2. Idiosyncratic (stock specific) risk
As an investor owns more and more equities stock specific risk (#2) goes down. It is theorized that once you own “the market” idiosyncratic risk is mitigated and only market risk (#1) remains as the dominant risk. Importantly, reducing stock specific risk also means that the possibility of any extra return from stock specific sources will also be reduced. In general, as more stocks are added the marginal benefit of diversification gets smaller and smaller with each addition. Think of it this way, if you own 10 stocks and add 1 more the diversification benefit can be very large. However, if you own 477 stocks and add 1 more the benefit can be quite small. In our example above, it did not matter if our investor owned 500 equites or 5,000 equities, the losses were still roughly 34%. Our investor had diversified away stock specific risks but was still fully exposed to market risk. The exogenous shock of the Covid Pandemic exposed the market risk embedded in these Indices and rendered the equity asset class diversification useless.
The takeaway here is that diversification within an asset class, stocks in our example, is not enough to mitigate market risk and protect investors against large drawdowns.
Addressing Market Risk With Bonds
Investors must go beyond stocks to address market risk. Investors typically address market risk by adding other asset classes to their investment portfolio. The obvious one is bonds (fixed income). Bonds have different sources of risk and return. Let us consider the typical 60/40 portfolio, i.e., some combination of 60% stocks and 40% bonds. In the US this portfolio could have a benchmark that is 60% S&P 500 Index and 40% Barclays Aggregate Bond Index. For our analysis we will focus on US Treasury Bonds rather than the Barclays Aggregate Bond Index. Attempting to address stock market risk with a bond investment implicitly relies on the two asset classes being either non-correlated or negatively correlated. After all, if they move together (positively correlated) there won’t be much, if any, of a diversification benefit. Given the importance of stock and bond correlation, i.e., how they move together, we should examine the relationship. The following chart plots the returns of the S&P 500 Index (SPX Index) and The Bloomberg US Treasury Index (LUATTRUU Index) from November 1972, through November 2022, 50 years of data. The section below the chart measures the way they move together (correlation). The correlation is measured in monthly intervals for 2 years (24 periods). Negative correlation is red, and positive correlation is green:
(Source: Bloomberg)
From 1975 until 2000 the relationship between the S&P 500 and US Treasuries was predominantly positive. There were two small periods during the late 1980’s and late 1990’s where the relationship was slightly negative. Recall, non-correlated (around 0) or negatively correlated suggest potential diversification benefits. Since 2000 the relationship has been predominantly negative, suggesting strong potential to diversify the S&P 500 Index with US Treasuries. However, in early 2022, which measures the last two years, the relationship changed. US stocks and US government bonds are now moving together.
What caused this? In our opinion, this was caused by the rapid increase in interest rates. Specifically in our example, the increase in the yield on the 10-YR treasury note. The following chart now shows the 10-YR US Treasury yield since 1972 monthly. The prior correlation analysis remains below the main chart:
In September 1981 the 10-YR Treasury peaked at 15.84%. Since the mid-1980’s there was a structural decline in this yield ultimately bottoming in July of 2020 at 0.53%. Since bottoming, the yield on the 10-YR has rocketed higher, ending October 2022 at 4.05%. This is the first time the 10-YR yield has breached 4% since May of 2008. Most importantly, the two blue circles highlight that during this recent period of rising interest rates the correlation between the S&P 500 Index and the Bloomberg US Treasury Index has turned positive. Not only has the relationship turned positive, but the level of positivity is the highest since the mid 1990’s. The rapid increase in yield, and the positive correlation between stocks and bonds, has coincided with the worst drawdown of the 60/40 portfolio ever.
The important takeaway here is that the relationship (correlation) between stocks and bonds changes, it is not constant. Using bonds primarily to address equity market risk at the portfolio level comes with substantial basis risk. Bonds are not a perfect hedge to equity market risk. Bonds have their own sources of risk and return. Quite simply, sometimes they work and sometimes they do not. At certain times like the Great Financial Crisis (2008-2009) and the COVID Drawdown (Feb-Mar 2020), US Treasuries were fantastic diversifiers and protectors of investment portfolios. This year bonds have been bad across the board. The majority of stocks and bonds have moved in the same direction.
Conclusion
To answer the question “does diversification work?” requires a complete understanding of portfolio risk. Diversification does work but it is important to understand its limitations. Diversification does work within an asset class, like stocks, as it can reduce stock specific risk to the desired level. However, adding hundreds, or thousands of different stocks will not necessarily address market risk. Equity diversification alone may not work in protecting a portfolio during periods where market risk dominates - when you need protection the most. Adding bonds to a portfolio adds diversification over time, but the level of diversification is inconsistent. During certain time periods bonds have been fantastic diversifiers. These periods are usually ‘flight to safety’ periods characterized by investors piling into the US government assets, driving bond yields down. But during other periods, like year-to-date 2022 when interest rates are rising, bonds have offered little to no diversification benefits. Of course, bonds can be added to diversify investment portfolios, but investors should be aware that bonds are inconsistent in addressing equity market risk, i.e., there is a basis risk from using an asset that is not a perfect hedge to the risk that is being addressed. Investors should be aware of both the stock specific risk and the level of market risk in their portfolios. That risk awareness may allow advisors/portfolio managers to use additional tools beyond bonds to address specific risks at the portfolio level.
Investment advisory services are offered through Brave Eagle Wealth Management, LLC; a New York domiciled registered investment advisor. Brave Eagle Wealth Management, LLC. 110 Wall Street New York, NY 10005.
