My coworker and I were talking this morning.  Laughingly, he said, there’s no such thing as diversification anymore.  What he meant was that it appears that markets are moving in tandem, and so the benefit of diversification appears lost.    He said it laughingly because he knew that both of our convictions are the same and that we were both already thinking about how to address this kind of statement when it comes up.  This is the extent of our predictions at MAMC.

A few times today, I heard through coworkers or through an article somewhere on the web, that investors are concerned about being invested internationally.  That’s understandable.  The Eurozone economy is facing sovereign debt problems and as Thomas Friedman says, the world is flat - or in other words, globalization has taken root and world economies are more and more intertwined.

Today, the S&P 500 closed almost 4% down.  In other countries, some markets fared even worse. What is the benefit of diversification?  Where would your portfolio be if you were invested 100% in Greek government bonds?  Would you have been slightly better off if you added in sovereign debt from other European nations?  Probably, yes.  Would you have been even better off still if you added in other international securities from around the world?  Again, most likely, yes.  Why?  Because some parts of your portfolio would not have suffered the same magnitude of losses earned in the Greek government debt securities.

It is not historically normal for global markets to move in tandem.  Though losses may be abundant across asset classes, the magnitude of each market’s move is not the same - thus diversification is still completely valid.  To concentrate assets in one asset class is very risky, just as it is to concentrate in one stock.  What if your concentrated position goes the route of AIG or Greece?  How can you minimize the risk and ultimate damage that such a position would have on your portfolio?  The answer is simply to own securities around the world and to control exposure to the more risky asset classes.

How you allocate assets in a portfolio is important, but diversification, patience and discipline are critical.  If your foundation is strong, then the unknown events of the future will be easier managed.

In an article by Dan Richards, “The True Cost of Volatility,” he explores what volatility means (and costs) in a practical sense. If one looks at the growth of a highly volatile asset class, one will see remarkable growth of wealth. There will be lots of ups and downs, but over the long-term, the asset class will show an overwhelmingly positive end result. One might then surmise that making that asset class a larger part of a portfolio is a smart move. Unfortunately, the volatile ups and downs are often overshadowed by that elusive ending value that displays a significant total return over a long time-period. The problem is that volatility is real, and tolerance to downward market swings is thin-skinned.

A study by Morningstar, looking at 10-year annualized returns (ending 2007), that accounts for cash flows in and out of funds, found some interesting numbers.

An investor that held a specific sector fund did worse than the actual fund. How’s that possible? It has to do with the investor not being able to stomach the volatility. In balanced funds, investors captured all of the actual performance of the fund. The reason for this is that the balanced fund produced smoother returns that investors could swallow more easily for the full time-period. With the balanced funds, investors tended not to flee when returns were sub-par. One can see that an annualized 1.13% was given up due to investors’ distaste for higher risk. For all intents and purposes, we could look at this as an explicit opportunity cost associated with investing in specific sector funds for the time period researched.

Morningstar then looked at funds based purely on standard deviation, as opposed to sector funds versus balanced funds. A similar pattern to the above table was uncovered.

A couple of valuable takeaways result from this article. First, discipline and diversification are critical to successful investing. Second, risk can be increased beyond a tolerable state; at which point, more harm than good is often the result. Having a well-constructed portfolio means having a palatable portfolio that is naturally diversified, where the risk is just right, unforced errors are mitigated, and discipline requires little action.

The full article is here.