Modern investment theory holds that when some asset classes decline, others increase. This negative correlation, in investment speak, means that large dips (and spikes) are moderated, resulting in less volatility and more predictable returns--making it easier for investors to stay with their investment allocations through thick and thin.
This idea was severely tested between September 2008 and March 2009, when it seemed every asset class--regardless of type--declined together, causing massive losses for everyone. Some thought that asset allocation had failed, and that a new strategy was needed to protect against this type of unprecedented loss.
Asset allocation and diversification work based on the premise that not all sectors of the market increase or decrease together, nor to the same degree. Historically, the stocks of small companies and those of foreign companies have been more sensitive to market volatility, declining and rising more than their larger domestic brethren. Bonds, both long- and short-term, have tended to change value much less than stocks, and were often more sensitive to whether investors thought interest rates would rise or fall.
Keeping the Faith
Contrary to popular belief, asset allocation and diversification never promised to protect us from upsets to the entire system (systemic risk)--only from upsets to individual securities, or to individual sectors of the market. So when all markets decline at once, as they seemed to do in the fateful six months between September 2008 and March 2009, and investment portfolios take a nosedive, asset allocation is not to blame.
Certain asset classes did quite well, despite the systemic decline. For example, treasuries actually increased in value. So if a portfolio was 100 percent in treasuries, it did quite well. If a portfolio was half in treasuries, the loss was mitigated, but there was an overall decrease in value. Indeed, through the worst investing period in 60 years, many well-diversified portfolios declined by 20 percent or less. This fact is sometimes lost: Many investors' portfolios did not precipitously decrease in value. These decreases, while uncomfortable, were not catastrophic.
The real danger was not that asset allocation had failed in an individual's portfolio, but that the investor would lose faith in holding the portfolio until the markets improved. This was different than the stock market crash of 1987. At that time, the economy stayed strong, despite a one-day loss to the Dow Jones Industrial Average of almost 23 percent. In the wake of Black Monday, the economy continued to grow, there was no banking crisis, no massive unemployment, and there were still high-paying manufacturing jobs to be had.
Of course, this time was quite different. In the wake of the Great Recession, unemployment skyrocketed, banks teetered on the edge of insolvency, and investors feared they might lose a lifetime's worth of financial security. Some actually did. In the face of this kind of uncertainty, almost every investor thought about taking what assets they had left and leaving the markets. After all, they might be next on the unemployment line.
For some investors, it wasn't so much their own portfolio's actual performance that caused them to doubt the validity of asset allocation. Rather, it was their neighbor's 401(k) performance, the performance of the Dow and all the other economic conditions. After all, a decline of 20 percent in a well-diversified portfolio, while uncomfortable, is well within the expected range. Well-educated investors likely already knew that this level of decline might happen.
The most important service a good financial advisor provides is helping investors stay the course, even when markets are not performing up to expectations.
Planners who successfully counseled their clients to stay with the chosen asset allocation and to continue dollar cost averaging (investing the same amount of money, on a regular basis, regardless of market conditions), likely have clients who are now ahead of where they were in fall 2008--albeit marginally. If they managed to dollar cost average throughout the last few years, they were buying at fire sale prices. For these people, the Great Recession was an upsetting downturn that they ultimately turned to their advantage.
On the other hand, for those investors who went without professional advice, or who felt they could not hold their positions and left the market at its lows, it will be a long time--if ever--before they can make up the losses.
Take the case of one individual who sold out of his equity positions in March 2008, having lost half the value of his portfolio, and bought an annuity. For that person as well as those who failed to trust the principle of asset allocation, they experienced losses that sticking with a diversified portfolio might have cured within a few years. A client who was guided by his or her advisor to stay the course throughout the last downturn was well-served indeed.
Seth Becker is a Registered Financial Consultant and financial planner with Oakstone Financial Management in Gahanna. He can be reached at (614) 775-9469 or email@example.com.
Reprinted from the June 2011 issue of Columbus C.E.O. Copyright © Columbus C.E.O.