Marc Odo, director of research at software and business intelligence firm Informa Investment Solutions, discusses why diversification failed during the credit crisis.
Marc Odo, director of research at software and business intelligence firm Informa Investment Solutions, revisits some of the forgotten truths about diversification.
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In the wake of the financial crisis five years ago, many investors are questioning the value of diversification. For decades, the financial industry preached the idea of spreading out one’s investments across a broad collection of assets to mitigate risk. However, as markets plunged in unison in late 2007 through early 2009, the losses incurred were much higher than anticipated. This has spawned much debate over the usefulness of maintaining a diversified portfolio.
Why did diversification fail during the credit crisis? Was it a problem with the theory or the practice? I believe it was a bit of both. Many advanced mathematical theories are being discussed in academic circles to find better ways to quantify and model downside risks. But how these models are implemented is just as important.
Diversification promised that, by investing in uncorrelated assets, losses in one portion of the portfolio would be offset by gains in another portion. Overall, this produced a smoother, less volatile ride. But the opposite of that idea was lost along the way: if a portfolio’s investments are highly correlated, then volatility wouldn’t be reduced at all.