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When diversification does not work

We have been told of the benefits of diversification – that by diversifying our investment into broad range of assets where their returns were uncorrelated, the overall returns would be enhanced.  It is not the case this year as we are approaching the end of 2008.

It is estimated that the world stock markets lost almost $30,000bn in value.  Oil prices fell by more than two-thirds. House prices dropped.  Bonds – except government bonds – collapsed.  Even the art market is affected.  Yes, almost every asset behaved alike in 2008: it went down.This is unusual.  Because normally assets have their moment in the investment sun depending on the stage of the economic cycle.  The ‘classic’ market behaviour dictates that bonds and defensive stocks such as utilities, would perform well going into a recession; growth stocks do best coming out; so-called emotional assets like paintings, have no link to the economic cycle.  This year everything happened simultaneously – correlations converged on one!

Why was this?  The underlying reasons are leverage and diversification itself.  To illustrate, at the peak, the hedge funds controlled about $2,000bn of equity.  Leveraged three times that provided some $6,000bn of spending power.   They invested in everything from common stocks to convertible bonds to rare guitars.  While the assets are heterogeneous, the owners were not.  In tough times they behaved the same way: Fear.  They sold.

diversificationIt should be noted that hedge fund is only a manifestation of a broader phenomenon – leverage.  Accordingly, money markets that provided that debt were already struggling in 2007, when British bank Northern Rock went down.  They froze after Lehman collapsed – that’s why asset prices collapsed so fast afterwards.  The trough of cheap money used to purchase assets suddenly emptied.  Diversification was therefore fake.  That made a terrible investment year in 2008.  The good news, however is – if that deleveraging process is over – it could make for a happier 2009.