Market extremes are often marked by a surge in declarations by media pundits that the old paradigm is dead and new rules apply.

This was true in the tech market boom of the late 1990s. And it's true again today.

In the wake of the devastating losses in the recent bear market, the current thought is that everything we knew about asset allocation, diversification and long-term investing no longer applies.

Headlines are declaring the death of asset allocation. The articles attack diversification and a long-term, buy-and-hold approach. Effectively, we're seeing a revolt in certain corners against some of the most modern advances in investment strategies used to manage portfolios.

There's a wealth of academic evidence supporting these methods, commonly referred to as Modern Portfolio Theory. First posited by Harry Markowitz in the 1950s, MPT states that by combining risky assets (domestic stocks, foreign stocks, real estate, commodities, etc.) in a portfolio, you can increase your expected return, reduce your risk, or both.

The concept centers around creating a portfolio with less collective risk than any of its indvidual components.

However, this can only be true if the assets in the portfolio have low correlations with each other. Correlation is a measure of how securities’ prices move in tandem. For example, two stocks with correlation of 100% would effectively move in lockstep. They would be perfect substitutes for each other and it would not make sense to hold them both in the same portfolio.

Similarly, it would not make sense to hold two stocks with negative 100% correlation, since their returns would offset each other, netting to zero.While this is an oversimplification of the concept, it illustrates the case that generally it would not make sense to add securities which are perfectly correlated or perfectly negatively correlated in the same portfolio.

The ideal is to have all your asset pairs within a portfolio with zero correlation with one another. That means their returns are all driven by independent economic phenomena and there is no relationship between their returns. While this is the ideal, it is unheard of in the real world.

Clearly, as Figure 1 below shows, diversification did not help buffer portfolio returns during the bear market of 2008.

Large-cap, midcap, small-cap, and international stocks all were down significantly. This is not too surprising since these asset classes historically have had relatively high correlation with one another. However, emerging market stocks, commodities, currencies, and high-yield bonds have historically had low correlation to stocks and yet they too all declined sharply.

Figure 1

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