Why Diversifying Your Portfolio Is Getting Harder
Spreading out your bets makes sense, but it doesn’t always pay off.
One of the cruel facts about portfolio diversification is that it may or may not pay off in any given period. During periods of market stress, correlations often move higher as many asset classes tend to drop in tandem. And when times are good--such as 2021’s generally bullish environment--a diversified portfolio can lead to lower returns. During 2021, REITs, commodities, and U.S. stocks racked up double-digit returns, but other asset classes were less impressive.
The shifting landscape for both interest rates and inflation further complicates matters. After decades of relatively low inflation and generally declining interest rates, both measures have shown signs of a fundamental regime change. Thanks to supply-chain issues and resurgent economic growth, inflation has spiked to a 40-year high, and interest rates have already started edging up in anticipation of likely rate hikes from the Federal Reserve. As a result, the previously ideal conditions for stock/bond correlations are no longer in place, and correlations between stocks and investment-grade bonds have already flipped to positive territory. That, in turn, reduces the diversification value of bonds from a portfolio perspective.
In our 2022 Diversification Landscape, we took a deep dive into how different asset classes performed in 2021, how these asset classes’ correlations have changed, and what those changes mean for investors and financial advisors trying to build well-diversified portfolios. We also looked at the diversification benefits of adding various assets to a U.S. equity portfolio, including taxable bonds, municipal bonds, international equity, commodities, alternatives, sector-specific indexes, investment styles, factor indexes, and cryptocurrency. (Morningstar Office and Direct clients can find the full paper here.)
The upshot: Diversification still works, but it's not easy.
Diversification has often been called the only free lunch in investing. As Harry Markowitz first established in his landmark research in 1952, a portfolio’s risk level isn’t just the sum of its individual components but also depends on correlation, or how the holdings interact with each other. Correlation is a statistical measure that ranges from 1 to negative 1 and captures how two securities move in relation to each other (although it captures only the direction, not the magnitude, of those movements).
Combining asset classes with correlations below 1.0 reduces the portfolio’s overall risk profile. It's one of the few cases where the whole can be more than the sum of the parts; a well-constructed portfolio can have better risk-adjusted returns than its individual components.
The problem is that correlation coefficients shift over time, so what worked in the past won’t necessarily work in the future. In addition, adding asset classes to reduce volatility can also drag down returns, sometimes over multiyear periods. Moreover, asset-class correlations often climb during periods of market crisis--exactly when you need diversification the most.
Because many investors have significant holdings in U.S. equities, we used that as our starting point (as represented by the Morningstar US Market Index). We measured the diversification value of different asset classes relative to this benchmark.
While basic portfolio diversification proved its mettle during the coronavirus-driven bear market in early 2020, 2021’s generally bullish environment was less kind to diversified portfolios. Simply adding bonds to create a basic 60/40 portfolio would have detracted from results as fixed-income securities started selling off in anticipation of eventual interest-rate increases. Allocating a portion of a portfolio's assets to bonds would have reduced risk (as measured by standard deviation) but also would have led to lower risk-adjusted returns.
More-diversified portfolio strategies would have fared even worse relative to an all-U.S. equity portfolio. To test the value of portfolio diversification, we created a diversified portfolio made up of 11 different asset classes. We allocated 20% of the portfolio to larger-cap domestic stocks; 10% each to developed and emerging-markets stocks, Treasuries, core bonds, global bonds, and high-yield bonds; and 5% each to small-cap stocks, commodities, gold, and REITs. With the exception of REITs and commodities, every “diversified” asset class fell behind the Morningstar US Market Index for the year. Thanks to slightly lower correlations between many of these asset classes, the diversified portfolio would have done a better job reducing risk than the basic 60/40 portfolio, but risk-adjusted returns fell behind.
The poor showing for diversified portfolio strategies in 2021 continues a longer-term trend. Although different periods tell a different tale, our test portfolio detracted from risk-adjusted returns over nearly every three-year period going back to the one starting in June 2010. The basic 60/40 portfolio, on the other hand, improved results in more than 90% of the trailing three-year periods.
Diversification’s failure to add value mainly reflects the confluence of strong returns for plain-vanilla stocks and bonds and weaker results for more-specialized areas. In addition, market correlations often converge during periods of market crisis, which happened across most major asset classes (Treasuries and cash were notable exceptions) in early 2020.
Correlations have also trended up over longer periods for some major asset classes, which reduces the value of diversification. Correlations between U.S. and non-U.S. stocks, for example, have significantly increased over the past 10 years. Even areas often touted for their diversification benefits--including REITs and some commodities--have often moved more in tandem with the broad U.S. equity market than investors might expect. In aggregate, the correlation coefficient for the diversified portfolio versus the Morningstar US Market Index rose to 0.95 for the most recent three-year period, compared with 0.82 for the three-year period ended in December 2004.
But that doesn’t mean portfolio diversification is fundamentally broken. For one, there’s no guarantee that correlations will remain at relatively high levels forever, although there’s some evidence that correlations between stocks/and bonds would probably move up during an extended period of rising interest rates and/or rising inflation.
In addition, portfolio diversification has still added value over some previous periods. As shown in the table below, the basic 60/40 portfolio produced the best risk/adjusted returns over the trailing three-, five-, and 10-year periods ended in 2021, but the diversified portfolio came out ahead for the trailing 20-year period.
Even so, investors looking to build diversified portfolios must choose carefully and recognize the challenges of shifting correlations over time.