There was not much to celebrate in 2008 (obviously) — and very little so far in 2009. But one thing we did learn in spades recently: In down markets, asset classes tend to be correlated. That is to say, diversification is less useful during bear markets. In short, when things are really bad, they are really bad for lots of asset classes. In a research report put out in conjunction with a CFA Institute webcast recently, researchers found that in up markets (as defined by one standard deviation above their mean), world (ex U.S.) and U.S. markets had a correlation of 35 percent. But in bear markets (one standard deviation below their mean), the equity markets tend to move (down) together, with a correlation of 85 percent. A similar condition exists in fixed income. In short, according to co-author Sebastien Page, diversification lends you an umbrella when it is sunny and then demands the umbrella back when it starts to pour.
What to do? Alas, “The Myth of Diversification” paper (Page's coauthors are David Chua and Mark Kritzman) didn't have many answers. But we suggest you do what some other well-known investors sometimes do: Avoid asset classes that appear to be way over priced based on historical averages. That's often disparaged as market timing, but there doesn't appear to be a simple answer to avoiding the catastrophic losses we have recently faced — other than by abstaining from “over-valued” assets.
