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Diversification risky as markets fall lock, stock and barrel

Portfolio

The sell-off in global stock, commodity and currency markets over the past two weeks has been brutal. The Hang Seng Index is down by 8 per cent, the rupiah by 10 per cent, copper by 13 per cent and the poor old Sensex, the main Indian stock index, by a wrenching 15 per cent.

But it is not only the values of the assets in investors' portfolios that have suffered. One of the most cherished tenets of modern investment theory has taken a hammering too.

Over the past couple of years, individual and professional investors alike have worked hard to diversify their portfolios. Many have gone beyond the traditional combination of domestic stocks and bonds, allocating a portion of their money to more esoteric asset classes such as emerging market equities, commodities and hedge funds.

Each of these newly introduced asset classes has a history of high volatility and, by itself, each would be a risky investment. But their performance histories show that in the past each has typically had a low or even a negative correlation with the more traditional asset classes.

In other words, when developed market equities were drifting sideways, emerging market stocks might well have been rising. Alternatively, in an equity bear market, there may have been a bull market in gold, or hedge fund managers might have been making a killing.

So, goes the idea, by introducing a few risky assets to your portfolio, you can boost your returns during tough times in your core markets.

Diversification is not just a clever pitch dreamed up by a broker to earn more commission. The idea has an impressive academic pedigree.

It is a core element of the modern portfolio theory which won New York university professor Harry Markowitz the 1990 Nobel Prize in Economics.

In a nutshell, Professor Markowitz said every portfolio has an optimum asset mix - called the efficient frontier - which gives the best possible return for any predetermined level of risk. Put the other way around, for any expected return, there is an optimum asset mix with the lowest possible risk.

Diversification is a powerful theory, backed up by plenty of historical data. But in practice it has a fatal weakness.

Over the past few years of meagre bond yields and lacklustre equity returns in developed markets, even the most risk-averse investors, such as teachers' pension funds, for example, have been persuaded to allocate a portion of their assets to uncorrelated exotic investments such as emerging market stocks or commodity futures.

The trouble is that the more institutional investors have invested in these assets, the more closely they have begun to march in step, both with each other and with stocks and bonds.

These markets were not correlated in the past because they were driven by different participants and different forces. But as ordinary investors have piled in, the prices of these formerly exotic assets have increasingly been influenced by the same capital flows that drive traditional asset prices.

As a result, when the big investors decided to reduce the exposure of their portfolios a couple of weeks ago, they began selling off their riskier holdings in unison. Assets such as Asian stocks, gold, copper and oil, originally purchased as diversification plays, all plunged together, falling in line with stock markets in Europe and America. The benefits of diversification were lost.

In fact, the attempt at diversification has ended up counting against investors. Although exotic assets have fallen into step with traditional assets, they have remained more volatile, which will have compounded losses over the past two weeks.

None of these means Professor Markowitz was wrong. It just means that in future investors will have to take care when they buy exotic assets that they really are diversifying their portfolio, not just doubling up their risk.

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