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.