The 2008 Crash - Case Study in Diversification

Diversification is meant to help protect a portfolio by combining asset classes that do not move in tandem, that move in different directions in a particular time period, for example by moving sideways or up while another is going down (though over the longer term, all investments would be expected to move up, otherwise why would anyone invest in them?). The year 2008 witnessed huge drops of about 35% in the TSX in Canada and the S&P 500 in the USA. How well did various asset classes perform as a diversification tool? Did any go in a different direction, making a lie of the feeling that everything plummeted?

A few charts from Google Finance give us a pretty good idea:

Chart 1 - Real Estate, International Equities and Gold vs the TSX Composite

No diversification help at all - paralleled the TSX very closely and fell just as much

• real estate, as represented by the iShares Canada Real Estate Investment Trust ETF, symbol XRE
• international equities, represented by the iShares MSCI Europe Australasia Far East Index ETF, symbol EFA

Fair diversification effect - dropped some but not nearly as much as the TSX

• gold, as represented by the iShares Canada Gold Sector Index ETF of gold miners, symbol XGD

Chart 2 - Corporate, Government and Real Return Bonds

Superb diversification effect - did not fall and even rose a bit, which is a bit hard to see since the huge drop in the TSX compresses the scale so much

• government bonds, iShares Government Bond Index ETF, symbol XGB, maintained solid steady-as-she-goes value as investors flocked to safety during the worst of the crisis
  

Fair diversification effect - dropped some but not nearly as much as the TSX

• real return bonds, iShares Canada Real Return Bond ETF, symbol XRB
• corporate bonds, iShares Canada Corporate Bond ETF, symbol XCB, which fell as much as 6% at one point but slowly recovered and surpassed government bonds by early April

Observations

1. Diversification works - having a hefty bond holding, as most well-constructed portfolios do, would have limited the damage of the equity crash
2. Diversification may not work the same way in the next downturn and different asset classes may be the ones to hold their value e.g. if inflation begins to ramp up, one would expect real return bonds and perhaps commodities to rise while bonds and equities would fall, at least in the short term. Or, conflict in an oil-producing area may boost commodities due to the petroleum component, while equities fall. Each crisis is different and it is hard to know which asset class will do best. That's why a range of asset classes in a portfolio is beneficial.