Research Brief

Bringing a Sharper Focus to the Study of the Decline of Investment Diversification

Research measures the impact of global economic factors on returns

If there’s one thing that big-time money managers and regular folks have in common, it’s a commitment to diversification. What the pros call modern portfolio theory (MPT), in a nod to the 1952 research that earned Harry Markowitz the Nobel Prize in Economics, is a gussied-up term for what the rest of us refer to as “not putting all my eggs in one basket.” Different name, same goal: No matter if your portfolio is $25 billion or $25,000, aim to reduce your risk by owning a mix of investments.

A central diversification law is that owning different types of assets — stocks, bonds, real estate for example — can mitigate risk to the extent those assets react differently to economic and market events.

Correlation is a long-popular metric used to divine the similarity/dissimilarity of returns from different types of investments, across different markets. Popular, but not exactly perfect. Assets that react to global economic developments by moving in the same direction, but to varying degrees, are deemed not to be highly correlated. For instance, in a global recession, if Asset A falls 15 percent and Asset B falls 28 percent they aren’t considered to be highly correlated. But that lower level of correlation doesn’t deliver much in the way of diversification, as you’ll have taken a big hit on both assets.

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John Cotter, of University College of Dublin Business School, UCLA Anderson’s Stuart Gabriel and California Institute of Technology’s Richard Roll set out to build a better diversification metric. They use return integration, which measures the extent to which the return of a given asset can be explained by a series of global economic factors. The absolute level of return is not important; their focus is on how much of an asset’s or market’s returns can be explained by external economic forces. That’s a more salient factor than correlation, if your goal is to build a globally diversified portfolio.

“While perfect integration implies that identical global factors fully explain index returns across countries, some countries may differ in their sensitivities to those factors and accordingly not exhibit perfect correlation,” the authors noted.

They constructed global indices for stocks, fixed income (five-year government bonds) and real estate investment trusts (REITs) and studied the extent to which performance between 1986 and 2012 was attributable to a series of 16 global economic factors that included U.S. stock and bond volatility and the percent of citizens in a given country using the internet.

In their model, the scoring is on a scale of zero to 100. A score of 100 connotes there is very little integration, and thus maximum diversification potential. A score of zero means there is no diversification value.

Their research confirms that we are investing in an increasingly integrated world.

“Diversification indexes for the equity, sovereign debt and REIT asset classes decline from a maximum level of 100 in the late 1990s to roughly half that level by 2012!” they wrote in Nowhere to Run, Nowhere to Hide: Asset Diversification in a Flat World.

The results weren’t any better when the three asset classes were combined — much like many an investor portfolio — into one index. Diversification scores of near 100 as recently as 20 years ago dropped to around 60 in 2012.

Additional slicing and dicing failed to unearth a market or economic condition in which diversification’s value in 2012 was anywhere near the levels of 10 and 20 years ago. The data were much the same when the researchers zeroed in on bull markets and bear markets, and periods of low and high volatility for both stocks and bonds.

Although the researchers found that global diversification is less effective across the board, some assets are holding their diversification value better than others.

While stocks from global developed markets trended down from 100 in 2006 to 50 in 2012, emerging market stocks had a less precipitous drop in diversification firepower, falling from 100 to 80.

There’s also wide divergence within the United States. The diversification value of stocks plummeted from above 90 in 2005 to below 60 in 2012. Bonds also had a fall-off in diversification value, but a slide from 100 to 80 was less dramatic, meaning U.S. bonds continue to offer relatively more diversification than U.S. stocks.

Far from a wonky academic exercise, the study is proof there is a real-world cost to the shrinking diversification payoff. The researchers document that as the diversification value of their global portfolios declined, risk — measured as standard deviation — increased, more than doubling since 1986.

Diversification may not yet be as expensive as lunch with Warren Buffett, but given the rising risk that comes with the breakdown in diversification’s super powers, nor is it free either.

Featured Faculty

  • Stuart Gabriel

    Arden Realty Chair; Distinguished Professor of Finance; Director, Richard S. Ziman Center for Real Estate at UCLA

  • Richard Roll
    Professor Emeritus, Joel Fried Chair in Applied Finance

About the Research

Cotter, J., Gabriel S., & Roll, R. (2016). Nowhere to run, nowhere to hide: Asset diversification in a flat world.

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