The third quarter of 2008 was, in words that may be an immense understatement, a remarkable period in the global capital markets. A rolling, slow-motion market crash has savaged one asset class after another, and volatility continues into the new quarter. Risk-reducing asset allocation has proved to be nearly impossible because all asset categories except the most liquid of nominal Treasuries have experienced significant declines. Even the few positive holdouts in the first half of the year—notably, commodities—gave way in the third quarter to sizable losses. And the dramatic reversals in prices weren't restricted to asset classes; it occurred also for individual stocks as, in three short months, yesterday's relative heroes transformed into laggards.

In times like these, it's helpful to review historical relationships for insights into what might happen in the future—both with asset allocation generally and in the cross section of the equity markets.

Asset Allocation

The financial crisis turned into a full-fledged market panic in September 2008, as many global financial Titanics—which had been deemed too big to sink—slipped beneath the waves or ran aground, where they required massive public and private rescue efforts.

Investors of all types suddenly reassessed their risk appetites. Just how big is this iceberg of bad loans? Where will the shifty subprime shoals surface next? Without clear answers, investors began summarily liquidating all risk exposures, culminating in the enormous September 29 equity market sell-off. Figure 1 provides September and third-quarter returns from 16 major asset classes.

These numbers are ugly. Whoever coined the phrase "The only thing that goes up in bear markets is correlations" couldn't have come up with a better case study. Many of these asset classes have unique return drivers and risk exposures, yet they all sold off. Diversification was of no help.

To gauge the improbable nature of this lockstep sell-off, we list in Table 1 the relative rank of September's results for each asset class since January 1988. Incredibly, September ranked in the bottom decile of absolute monthly performance for 14 of the 16 asset classes, including four (long-term credit, high-yield debt, bank loans, and developed market non-U.S. equity) that experienced their worst month of absolute performance in the last 20 years. REITs and long-term Treasuries were not in their bottom decile ever, but even these classes were well below the historical median results for their class. Not a single asset class delivered results that were above the historical average—not one!

Diversification allowed a portfolio to avoid much of the drawdown until September. Figure 2 shows the cumulative 2008 performance of an equally weighted (EW) portfolio of the 16 asset classes in Figure 1 and Table 1 with the performance of a traditional 60%/40% U.S. stock/bond mix (with stocks represented by the S&P 500 Index and bonds represented by the Lehman Brothers Aggregate Bond Index). Note how the diversified 16-asset approach largely avoided significant losses and dramatically outperformed the 60/40 mix until September. In the end, with almost everything producing historic losses, asset allocation was largely futile. Of the 16 asset classes, 15 finished September in the red, which resulted in the equally weighted basket producing a return of -6.74%. The magnitude of this loss was exceeded only by the decline of -8.34% of August 1998 (largely ascribed to the collapse of long-term capital management). The five worst months since 1988 are presented in Figure 3.

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