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By adding assets such as those in Figure 3 to a portfolio (and by extension, reducing the existing stock and/or bond allocations), the investor hopes to lower total portfolio volatility, increase total portfolio returns or generate some combination of higher returns and lower volatility. This proved effective during the bear market from 2000 through 2002 (U.S. stocks returned -42 percent), during which REITs (+44 percent), commodities (+37 percent), international bonds (+19 percent) and high-yield bonds (+5 percent) realized positive returns, providing considerable diversification potential.9 However, while many assets are imperfectly correlated over time, the long-run historical correlations may not hold during short-term periods of acute market stress. This is because during a flight to quality, increased systematic risk tends to swamp asset-specific risk, and risky assets have a tendency to suddenly become more positively correlated, often in contrast with how they perform during "normal" times. This also highlights an important distinction—risk diversification, such as that achieved through U.S. Treasury bonds, versus return diversification, such as that achieved through REITs or emerging markets equities. As we will see, in normal times, the differences between the two may be minor, but during events characterized by a flight to quality, the differences and implications can be significant.
From 1988 through 2007 (1988 representing the start of the emerging markets data series), a portfolio that allocated 50 percent to U.S. stocks and 50 percent to U.S. bonds would have averaged a 9.9 percent annual return with a standard deviation of 7.4 percent. On the other hand, a portfolio equally weighted among the six categories of assets shown in Figure 3 in addition to U.S. stocks and U.S. bonds (12.5 percent allocated to each) would have averaged a 10.9 percent annual return with a standard deviation of 7.6 percent (see Figure 5a).10 In hindsight, it is clear that it would have made sense to invest in the more diversified portfolio over this particular period.11 But the "long-term history" for many types of assets is not nearly as long as that of U.S. stocks, bonds and cash, for which we can reliably go back to at least 1926, a period covering many economic and market regimes. For many of the asset classes and subasset classes commonly used to diversify equity market risk, we can only go back 20 or 30 years, a period characterized by disinflation, long intervals of relatively low volatility and a relatively stable economic environment. As is now widely known, the global equity bear market that started in October 2007 and lasted through early March 2009 was unique in many respects. The global financial crisis was characterized primarily by a flight to quality. And in a flight to quality, risky assets tend to perform more similarly than differently. Figure 4 shows the observed correlations for the same assets from October 2007 through February 2009. Comparing the long-term correlations in Figure 3 with the correlations presented in Figure 4, we can see the impact of a flight to quality. Correlations both to U.S. stocks and U.S. bonds increased significantly—virtually across the board. As a result, the long-term diversifying properties at least temporarily largely disappeared.12
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