On Sept. 15, 2008, Lehman Brothers, the fifth-largest investment bank in America, declared bankruptcy. The firm had more than $600 billion in assets, and its bankruptcy case became the largest in U.S. history.
More importantly for investors, the Lehman Brothers downfall set off a precipitous decline in stock prices worldwide.
The cumulative decline in U.S. stocks from the October 2007 high to the March 2009 low was 57 percent, the worst bear market since the 1930s.
One characteristic of this bear market was the simultaneous crisis in the credit markets, due to Lehman's global involvement in financial transactions. The seizing of credit was the catalyst for massive selling of virtually all assets in the fall of 2008.
In this crisis environment, the correlation among asset classes converged, temporarily reducing the normal benefits of portfolio diversification. Global stocks, corporate bonds, municipal bonds, commodities, real estate and other asset classes all declined in value simultaneously as the "mother of all margin calls" hit leveraged institutional investors, forcing them to sell indiscriminately to raise capital.
The extreme environment of the past year proved to be a real test for the integrity of certain basic principles of investment management, including these traditional tenets:
• Diversification reduces portfolio risk;
• Risk and return relationships among asset classes are persistent; and
• Asset class returns tend to gravitate back to their averages over time, irrespective of recent trends.
In the midst of the extraordinarily volatile months of last fall, investors undoubtedly wondered if it was different this time.
But one year later, the market's response to this recession and the unfolding recovery have proven that the basic principles anchoring sound investment strategy are still valid.
Despite the temporary crisis-driven increases in correlation in late 2008 and early this year, the benefits of diversification are apparent in trailing statistics. Here are some examples, based on investment returns for the one-year period ending Sept. 15 - the one-year anniversary of Lehman's demise.
• High-quality taxable and tax-free bonds both produced solid returns for the period, as indicated by the Barcap Aggregate (+6.79 percent) and Barcap Municipal (+7.11 percent) indexes.
• International stocks experienced less than half the decline of U.S. stocks (MSCI EAFE International index: -4.63 percent versus the S&P 500 index: -9.34 percent).
A simple diversification model balanced between high quality taxable bonds and S&P 500 stocks would have resulted in a return just below even, at -1.27 percent.
Granted, equity values were much lower at certain points within the past year than they are today. However, most investors who stuck with a well-conceived investment plan have been rewarded with the ability to recover a significant portion of the value lost during 2008. This value recovery has continued through mid-November, with the U.S. market gaining more than 23 percent year-to-date through Nov. 13, while international stocks are up more than 32 percent for the year, according to Morningstar, with U.S. stocks represented by the S&P 500 Index and international stocks by MSCI EAFE.
The past eight months also have offered a unique opportunity to broaden diversification across a variety of attractively valued global asset classes, allowing investors to improve portfolio characteristics going forward as risk/return relationships normalize.
The dual bear markets of this decade have undoubtedly shaken the confidence of most investors and disrupted their progress in achieving financial goals.
Entering 2010, there likely will be new challenges for the U.S. economy and markets to overcome.
Now more than ever, employing an investment discipline that includes broad diversification across global asset classes will play an important role in risk management and also in achieving financial objectives.[[In-content Ad]]
Jeff Layman is chief investment officer of BKD Wealth Advisors in Springfield and a Chartered Financial Analyst. He may be reached at jlayman@bkd.com.
