Diversification: Great in the good times, a disappointment during the financial crises

Traditional diversification did not serve investors well during the financial crisis. Due in large part to leverage, the correlation among most asset classes increased significantly and practically every asset class, with the notable exception of U.S. Treasuries, delivered extreme negative returns.

The lesson is not that diversification, in principle, is useless. That would be the wrong lesson. The application of the principles of diversification was flawed. Diversification was more apparent than real in that many of the traditional asset classes had similar return drivers (including the equity risk premium). One risk factor, leverage, used excessively, swamped most other risk factors, which in normal times would have differentiated the various asset classes.

The financial crisis demonstrated that the equity risk premium is tied closely to the credit risk premium, which, in turn, is linked to the economy. Leverage increases the correlation between equity (stock) and credit (bond) risk. Thus, bonds provided much less diversification to the entire portfolio than most investors would have expected.