Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 68

Diversification lessons from the GFC

In part 1 of this trilogy we reviewed the work of Harry Markowitz and William Sharpe, whose ideas shape our understanding of diversification, the foundation stone on which modern portfolio theory sits. In part 2, we look at risk in a diversified portfolio, and how well diversification performed in Australia during the Global Financial Crisis.

Diversification and superannuation governance

All Australian superannuation funds must adhere to the investment strategy operating standard embedded within legislation which (in part) states that the trustee of a super fund must:

“….formulate, review regularly and give effect to an investment strategy that has regard to…the risks involved…and the likely returns from…the entity’s investments, [as well as]….the composition of the entity’s investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification.”

The Markowitz/Sharpe language of expected (likely) returns, risk and diversification is explicitly included. As every superannuation trustee is legally obliged to meet the above operating standard, it applies equally to the 300-odd APRA regulated super funds as to some one million individuals who are trustee-members of SMSFs.

A 2007 government-funded financial literacy study found that whilst 55% of people considered potential returns when making financial decisions, only 34% considered risk and return together. More worryingly perhaps, only 5% considered diversification. How therefore should we assess our exposure to “risks from inadequate diversification”?

Diversification by capital and by risk

In the previous article investment diversification was illustrated with reference to a pie chart for the average default APRA-regulated superannuation option. The current average default option holds some 61% in property and equities, 22.5% in cash and fixed interest and 16.5% in alternatives strategies. The chart from Part 1 is reproduced below left.

The chart on the right indicates how much each asset class contributes to total portfolio volatility (based on monthly data for the ten years ending December 2013). Australian equities, whilst comprising 26.5% of capital, contribute almost 36% to portfolio volatility. International equities and Australian property likewise add more to portfolio risk than their respective capital allocations. Alternative strategies, taken together, are the only growth-like asset class that contributes less to portfolio volatility than to capital allocation. [Editor’s note: The risk and volatilities contained within the alternatives asset class varies widely depending on what alternatives are used.]

In the average default super option today equities and property account for some 61% of capital, but more than 90% of portfolio volatility. To determine why, one first needs to understand the effect of asset co-movement.

Correlation – the key to diversification

The objective of intelligent diversification is to find investments that do not move together in response to the same stimulus, but will in aggregate provide a satisfactory return. Asset co-movements are generally measured either by covariance or correlation. A correlation coefficient is always bounded by -1.0 and +1.0. Risk is effectively nullified if a portfolio consists of two assets with a correlation of -1.0, similar to sound waves of equal but opposing amplitude. A correlation of +1.0 implies two assets with perfectly synchronous movement, providing no risk reduction benefit at all.

Harry Markowitz’s key insight was that if you could accurately forecast the return and risk of each security in a portfolio and their various correlations, you could create a diversified portfolio optimised between risk and return based on your risk tolerance. In determining what he called ‘relevant beliefs’, Markowitz suggested reviewing historical statistics and adjusting these for “factors or nuances not taken into account by the formal computations”. In other words, the best guess as to what might happen in the future is that which has occurred most frequently in the past, adjusted for any ‘relevant beliefs’ as to future market movements.

Taking the Markowitz approach, the following risk (standard deviation) and correlation statistics compare each asset class with the diversified default option portfolio shown in the above pie chart:

The statistics above reveal why the risk allocation chart differs so markedly from the asset allocation chart. In a portfolio where growth assets dominate, the high volatility of equities and property imposes an outsized influence on total portfolio risk; an influence that low volatility cash and bonds cannot overcome despite the risk dampening effect of their negative correlations.

All the above is wholly consistent with William Sharpe’s pricing model, which holds that higher risk must accompany higher expected returns in order for capital markets to clear. But what of diversification during the GFC? Did it fail when needed most?

Diversification and the GFC

Let’s examine the correlation of Australian equities to other asset classes below:

The movement of growth assets did indeed become more synchronous during the GFC. That Australian and global equity correlations increased in the midst of such a downturn should not have surprised. The increased correlation between Australian equities and Australian property was, at the time, less expected and was a result of listed property trusts (A-REITs) having become more equity-like in the years leading up to 2007.

Placing $10,000 in each of the following on 1 January 2008, generating index returns with no contributions, withdrawals, fees or taxes resulted in the following capital value changes by year’s end:

The above data dispels the notion that diversification’s protective qualities disappeared completely during the depths of the GFC. Whilst capital loss was greatest in equities and property, the diversified portfolio’s weighting to these assets was partially offset by strongly positive cash and fixed interest returns, and by lowly-correlated alternative asset strategies that fell only marginally by comparison. Rumours of diversification’s death during the GFC appear to have been greatly exaggerated.

Where to now for diversification?

Diversification works in theory and it appears to hold up in practice. Where it is found wanting is in the assumptions it makes of the average investor’s ability to form ‘relevant beliefs’ as to risk, returns and correlations. Here modern portfolio theory appears somewhat detached from human behavioural reality, as I commented in the Cuffelinks article: The Harry Markowitz Interview, Part 2: Retail financial advice.

The concluding article in this trilogy will incorporate aspects of investor behaviour by considering an alternative approach to diversification in retirement planning.

 

Harry Chemay is a Certified Investment Management Analyst who consults across both retail and institutional superannuation, focusing on post-retirement outcomes. He has previously practised as a specialist SMSF advisor, and as an investment consultant to APRA-regulated superannuation funds.

The author would like to acknowledge Matthew Drzewucki, Investment Analyst at Equipsuper, for his assistance in the analytical work involved in preparing this article.

The total portfolio volatility analysis was conducted using monthly index returns for the period January 2004 to December 2013. Risk allocation is the historic co-variation between each asset class and the total portfolio, expressed as a percentage of the aggregate variance of the portfolio.

The following indices were used as asset class returns: Australian equities – S&P/ASX 300; Australian property – 50% Mercer/IPD Australia Property Fund Index and 50% S&P/ASX 300 A-REIT; International equities – MSCI World (ex-Aust) net AUD unhedged; Australian fixed interest – UBS Australia composite bond index 0+ years; Global fixed interest – Citigroup world government bond index AUD hedged; Cash – UBS 90 day bank bill index 0+ years; Other – 33.33% Cambridge Associates Australian Private Equity & Venture Capital index, 33.33% MSCI world infrastructure net AUD unhedged, 33.33% HFRI hedge fund composite index gross AUD unhedged.

 

RELATED ARTICLES

The long and short of hedge funds, Part 2

The long and short of hedge funds, Part 1

Diversification: past, present and future

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.