Question

Consider the recent 2008-2009 financial crisis:

1. Would the normal principles of diversification have worked for investors during this crisis? Why or why not?
2. What are lessons learned for the future?

Answer 1

Answer A.

During the financial crisis of 2008-09, the normal principles of diversification would have worked only to some extent. Just as an example, one of the principles of diversification is to invest in stocks diversified across industries. In addition, to invest in a mix of high beta and low beta stocks. However, specific to stocks, the financial crisis of 2008-09 was so broad based that each and every sector in the economy was negatively impacted and even low beta stock saw significant downside. Therefore, diversification within the stock portfolio would have not yielded results during the crisis.

At the same time, it is important to note that US stocks declined, real estate prices declined, commodities declined after a brief surge and global stocks also declined. Therefore, even diversification across asset classes and regions might not have yielded results during the financial crisis.

However, Treasury bonds surged during the crisis and it was a bull run for cash. Therefore, these two asset classes did outperform during the financial crisis of 2008-09.

Importantly, diversification helped during the financial crisis of 2008-09 just to the extent that investors who had money parked in Treasuries or cash gained. However, there was a broad based decline across asset classes and diversification within risky asset classes would not have worked during the crisis.

Answer B.

Some of the key lessons from the financial crisis of 2008-09 in terms of diversification are as follows -

1. It is always important to have exposure to risk free asset classes like Treasuries, cash and gold. These are asset classes that are most likely to trend higher even if all other asset classes decline.

2. In a globally synchronized economy, regional diversification is unlikely to work when there is a major crisis. US asset classes declined and at the same time, asset classes in emerging markets also suffered. Therefore, regional diversification is unlikely to yield results when the global economy is significantly interconnected.

3. Asset classes have been more volatile since the financial crisis of 2008-09. The implication is that its more important to have an actively managed diversified portfolio than a passively managed well diversified portfolio.