Doug of d-short fame looks at the above question, and concludes, not so much:

Diversification is a cornerstone of Modern Portfolio Theory and portfolio risk management. We spread our investments across a range of asset classes to ensure participation in the upside and reduce exposure to the downside. This is a time-honored strategy that works … most of the time. But during epic market downturns, asset classes tend to march to the same dismal drumbeat.

click for larger chart

via D-Short

Category: Investing, Technical Analysis

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

35 Responses to “How Well Does Diversification Work?”

  1. Melh says:

    Diversification sucks, I use Madoff–great consistent return. Oh, wait, that was last year.

  2. danm says:

    I think I’m going to put 100% in C. Too big to fail no?

  3. whskyjack says:

    It is all just one big poker game.

    “you’ve got to know when to holdem, know when to foldem, know when to walk away, know when to run”

  4. Rene Korda says:

    Well, actually it does work – if you diversify across all the assets available properly, you’ll be fine – when stocks fell, t-bills rallied and someone with exposure to both would do fine. There is a problem with diversification MPT-style however – it is done by looking at statistical correlations between different assets and asset pools either for a data taken from a certain period of time or produced by a certain model (which is usually based on the data from that same period anyway), thus if the market behaves in a different way then it behaved during that period the diversification might not work, as it will be based on a non-relevant data. Since, obviously, the long-term financial data available to us isn’t comprehensive enough in terms of covering all the possible states of the market – it is, most likely, impossible to diversify completely and almost impossible to have a robust long-term diversification without including some implicit knowledge of how the market functions.

  5. franklin411 says:

    Since when do normal rules apply in abnormal times? =P

  6. JustinTheSkeptic says:

    Did you say masterbation, that works in all markets; good for both the body and mind. Why don’t they make that a national add compaign? lol…

  7. cttfinder says:

    I hope Mr. Short’s not in a profession requiring analytic skills…he’s comparing apples and oranges here big time.

    The top graph is over a much, much longer time frame than the bottom graph – duh!

  8. ben22 says:

    Real in depth analysis here, wouldn’t you think that if you were properly “diversified” you’d have some fixed income in your portfolio? This is all equity.

    I don’t get it, a few posts before this is about how bonds have outperformed stocks, then a post that talks about how diversification doesn’t work but only looks at diversifying within equities.

    What the hell.

  9. ben22 says:

    one more thing, in order to see if the diversification worked, wouldn’t you need to run the second chart from 2000-2008 as to show over the entire period whether or not the diversification beat the S&P.

  10. DL says:

    Add commodities to the list of correlated assets.

    Also add many of the currency pairs “long X/short Y” in which “X” is the country of a commodity exporter, and “Y” is the country of a commodity importer;
    or else “long X/short Y” in which short term interest rates of country “X” are substantially higher than those of country “Y”, e.g., AUD/JPY.

  11. Marcus Aurelius says:

    The ultimately diversified portfolio – one holding equal values of all stocks, currencies and commodities – purchased one decade ago, would probably still be down today. I could be wrong (I’ll be damned if I’m going to go through the trouble of testing this hypothesis).

  12. when is “all Paper”= “diversification”?

    though, past that, “diversification”, usually means: “I have no Idea, but pay me anyways..”

    more subtle than a heavy rock, or a sock full of quarters, but, same difference really..

  13. DL says:

    Of course, the one key asset that has done very well over this time period is the 10 year
    Treasury note. Which makes one wonder how much longer the outperformance can last.

    By next year, a long S&P futures/ short T-bond futures trade should begin to produce good gains.

  14. 1001 says:

    MPT discusses asset class diversification

    Where are Bonds , Cash , Commodities in all this ?

    D-Short is “short ” alright

  15. call me ahab says:

    back in my finance classes back in the 80′s my professor had a sure fired way to minimize losses and maximize returns with, if I remember correctly, an optimal portfolio of 11 stocks, that were selected through a regression analysis. By back testing the professor’s model the class learned that the optimal portfolio would have less losses and higher returns than the S&P 500- but I always kept thinking SO WHAT! Gee I’ll have less losses- but they’re STILL losses. So . . . a broker’s best claim in a down year can only be that they lost you less money than the S&P 500 (not made you money) because all they rely on is diversification and the hope that the long term trend will remain up. My advice- don’t rely on a broker and don’t be afraid to be in cash.

  16. “..a broker’s best claim in a down year can only be that they lost you less money than the S&P 500 (not made you money) because all they rely on is diversification and the hope that the long term trend will remain up. My advice- don’t rely on a broker and don’t be afraid to be in cash.”


    sadly, or predictably, the MutFund mongers are hawking this message, as we speak..

    “sure, we had a ‘tough’ year, but we did better than the SPX, we ‘only’ lost ~20, 30, 35%”

  17. sunny45 says:

    Diversification should NOT stop at 0.1 to 1.0 Beta but should extend between 0.-01 thru +1.0 which will include inverse ETFs, puts and Bear MFunds.

    Depending upon the SECULAR Trend of the Mk. It can be Bull, Bear or Mkt neutral with Bull/Bear bias.

    This is how, I am able to navigate with minimal loss so far, from the peak of Oct 2007!

  18. Mich@TBP says:

    what is different time frames got to do with diversification? Nothing, it is ok that they’re different timeframes.

    What is wrong with this topic is to associate those charts as if diversification promises superior returns. Diversification is simply eliminating “company specific surprises” from your returns.

    I believe topic took diversification for “hedging”, therefore expecting that “downside shouldn’t have happened”. Well, you diversify so that you don’t take company specific risk (either for the company’s bonds or shares) but you will have “market risk”. With hedging you try to reduce market risk by balancing negatively correlating investments. Both hedging and diversification than ultimately means lower risk, lower returns.

  19. call me ahab says:

    @ Mich@TBP

    Sure- if you pick the winners in the S&P than you will get higher risk and higher returns- but if you pick the losers you have higher risk and lower returns.

    @ Hoffer

    that’s the game- “we lost less”- I saw a statistic that indicated the majority of mutual fund managers actually lose to the SPX- so . . . why not just put all your money in SPY and call it a day.

  20. ahab,

    I hear you re: “the majority of mutual fund managers actually lose to the SPX”, I was being charitable/ relaying a recent pitch some dudes were giving during a commercial break at a ‘nova v. Dook watch..

    re: SPY, that was Bogle’s insight pre-ETFs

    though, remember the SPX-investor breeds monocultures in the Economy..

  21. ben22 says:

    @ Mich,

    Time frame has everything to do with diversification. Isn’t that the whole idea?, not everything will do well at once, some things will do well when others don’t, etc. etc. That all means, in order for diversification to prove any value it needs time.

    The reason the time frame matters in this case is because the title of the article is does diversification work, then it shows an example of what an investor could have diversified in starting in 2000, shows what that would have looked like from then until the end of 2007.

    then it shows when it doesn’t work,during a time frame of 1 year, and again, it’s a poor example as this is all equity.

    If you were trying to figure out if your strategy worked, you could need to go back to the start, not the most recent period.

    As for diversification = downside shouldn’t have happend, that is just ignorant, who really thinks this?

    And further, real diversification is more than just trying to avoid specific company risk, there are far more asset classes than stocks and bonds, as mark stated above, you don’t only have to allocate capital towards paper.

    @ ahab,

    Why not put all your money in SPY and call it a day?

    How’d that work out the last 12 years?

  22. the economic fractalist says:

    In a contracting global money supply, contracting available speculative money rotates among speculative stocks: observe the diversification, congruent. and trending lower, valuation saturation fractal patterns…. the value of the science of saturation macroeconomics is that it serves as a foundation construct for monetary policy……

  23. Kimble says:


    I did some further “analysis” and found that if you invested in the MSCI World Index over the last year (a VERY diversified index) you would have lost 41%! And if you had invested in the MSCI AC World Index you would have lost 41.5% and that index is even more diversified!!!

    So if have diversify between two of the most diversified indexes in the world you still get a hugely negative return!

    So much for diversification, eh guys?!?

  24. call me ahab says:

    ben22 says:

    “How’d that work out the last 12 years?”

    couldn’t say- read my comment from 4:07- certainly not my advice.

  25. sunny45 says:

    Diversification and risk avoidance

    The RISKS:

    Company/Stock specific risk, industry, sector risk, currency risk, geopolitical risk, liquidity risk and the market (bond and Stocks-domestic, developed, emerging etc), Black swan, Terrorism and Minsky moment kind of risk.

    Diversification with strategy allocation (?percent) of uncorrelated assets will reduce but not eliminate it. Market risk can be reduced ONLY by betting against it. Again the need and lack of appreciation of inverse ETFs and Bear MFunds in a portfolio is the biggest blind spot and the reason majority money managers incl MFunds lost big in 2008.

    The biggest unknown is the correct anticipation of SECULAR ,Bull vs Bear Mkt, ahead. This is my 2 cents!

  26. call me ahab says:


    but by reducing risk with inverse ETF’s in a stock portfolio you minimize potential returns- the objective is to finesse your portfolio in anticipation of your expectations of the market- that is where the money is made (or lost)- unless your objective, in a market where you are unsure of direction, is to minimize losses- best way to do that of course is cash.

  27. eric davis says:

    I’m not a big smart asset manager like you guys…. I always heard diversification was among asset classes.

    What Does Asset Class Mean?
    A group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments).

    So… you compare the same asset class against the same asset class, and strangely the same asset class is correlated to the same asset class…. that is WEIRD!!!

  28. call me ahab says:

    @ eric-

    I am with you Eric- you are making BR’s point however.

  29. wally says:

    Hmmm… something about ______ all boats.

  30. Keith D. says:

    Diversification is an attempt to level out the returns of your portfolio rather than the high volatility of just one stock. By adding in bonds to your equity portfolio, you lower your risk.

    When the S&P goes up, you will go up as well, but probably not as much. When the S&P goes down, your portfolio will go down, but not as much because you have bonds which act as shock absorbers. The key here is that over time, because you didn’t go down as far as the S&P did or as high as the S&P did, you’ll end up with a return just below the S&P 500. But, in doing so, you’ve minimized your losses in the down years and took advantage of the upsides in good years. The long-term trend is where diversification pays off.

    These graphs are innacurate in that if you created a portfolio that was weighted accordingly by MPT (with some bonds and then different asset classes of stocks), the portfolio would still be doing ok. You cannot diversify away all risk, the current downturn is associated with systematic risk. Diversification seeks to eliminate non-systematic risk of a single company. Using MPT can successfully achieve this result. So, while you may be asking yourself why you pay a broker for losing money, you need to ask yourself, over the long-term, am I eliminating non-systematic risk and am I losing as much as the S&P?

    The answer is yes and no. You’ve eliminated or reduced non-systematic risk which only leaves systematic risk. That’s what we’re dealing with now, so when your portfolio is down, don’t blame diversification. Diversification did its job, you aren’t down 70-80% because you invested all in C. No, you’re maybe down as much as the market or a little less than the market. That’s because diversification eliminated the non-systematic risk but you still have to deal with systematic risk.

    I think people think that diversification will always guarantee you a portfolio that performs in down years and outperforms in up years. It does not. It provides you with protection from non-systematic risk, that’s all. There is no good way to eliminate systematic risk and still get the returns of a diversified portfolio.

  31. noilifcram says:

    This shortsighted analysis does not account for portfolio re-balancing either. You cannot let your asset mix drift.

  32. FromLori says:

    I think most will find this interesting and disturbing at the same time.

    Told ya so again
    The Market Ticker ^ | 3/30/09 | Karl Denninger
    Posted on Mon Mar 30 2009 14:34:38 GMT-0500 (Central Daylight Time) by FromLori


    Under Millard’s strategy, the pension agency was directed to invest 55 percent of its funds in stocks and real estate. That included 20 percent in US stocks, 19 percent in foreign stocks, 6 percent in what the agency’s records term “emerging market” stocks, 5 percent in private real estate and 5 percent in private equity firms.

    What I warned of was the potential loss of your private pensions a few months back, if you remember.

    Here’s the formula for your impending doom, if you forgot:

    The S&P 500 goes to 300 as the “bailouts” and “handouts” collapse the economy. The PGGC’s equity investments are worth 20 cents on the dollar, the private equity and REITs are zeros. This puts the fund 40% underwater across-the-board. It is unable to pay and goes to Congress. Congress can’t fund additional borrowing because the bond market has dislocated. You get 10 cents on the dollar for your supposedly ‘guaranteed’ pension.

    (Excerpt) Read more at …


    Was This An Outright Scam? (AIG – Again)
    Hattip all over, including the forum and Zerohedge:

    During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent – these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were “we have never done as big or as profitable trades – ever”.


    AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

    Was it deemed “critically important” by Treasury that these employees remain under employment agreements – including perhaps confidentiality, one wonders, therefore necessitating huge “retention bonuses”, lest they leave and sing?

    Now the alleged mechanism for the conduit to shuffle AIG bailout money through to the banks, including banks not in the United States, comes out.

    All to “save the financial system” eh?

    There was no need for “new authority” was there Tim? All you had to do, if this account is correct, is tell AIG to stick it where the sun doesn’t shine (and send in a few cops) for making trades that were intentional money-losers and designed to stick the taxpayer with a monstrous (to the tune of $170 billion thus far) bill.

    Where are the cops?

    Oh wait – I know – they’re in New York!

    Paging Mr. Cuomo. Mr. Cuomo you have a call on Line 1!

  33. hazeleyes says:

    Quote: whskyjack Says:

    March 29th, 2009 at 1:31 pm
    It is all just one big poker game.

    “you’ve got to know when to holdem, know when to foldem, know when to walk away, know when to run”

    Yep. Too soon old, too late smart.

  34. [...] market crash. Nearly every asset class, whether it was bonds, stocks, real estate, or commodities, lost value. Many people have interpreted those results to mean that diversification doesn’t [...]