Question: Whatever happened to the supposed benefit of diversification? I diversified broadly, but everything has gone down
dramatically over the past year. Doesn't that kill the theory that diversification will moderate the impact of a downturn and help us grow faster with less risk in the long term?

Answer: Interesting, isn't it, how quickly people have been in this crisis to dump time-honored investing principles? Surf around the net a bit, and you won't have trouble finding any number of people pronouncing the death sentence on buy-and-hold investing, asset allocation, indexing, rebalancing and, of course, diversification.

The usual justification for this revisionism is "this time is different." I'd note that we also heard that rationale back in the 90s when investors decided that concepts like value investing and building a diversified portfolio were passe and that the "new era" way to make money was to put all your dough in the shares of dot-com companies that had no earnings.

So I'm skeptical when people are ready to jettison principles that, to my mind at least, are well grounded in the fundamentals of the economy and the markets, not to mention human behavior. I find that people who are eager to abandon principles often don't really understand them, and thus have unrealistic expectations.

Diversification still works. Diversification did work last year, even if it didn't get the investment results you might have preferred. You see, diversification was never designed to provide a guarantee against losses. No strategy can do that. Rather, the idea behind diversifying is that all your money won't be subject to the fortunes of one investment or asset class. So to the extent you spread your money around, you'll experience a broad spectrum of returns, not a single return on all your money.

I'm sure some people are saying, wouldn't I have gotten much more protection than diversification offered if I had simply bought Treasury bills at the beginning of 2008? And the answer is yes, you would have, if you had known in advance what was going to happen. Which brings us to the reason for diversifying: we don't know how different asset classes are going to perform from year to year or even over the longer-term. So to hedge your bets, you spread your money around.

As for your expectation that diversification moderates the impact of a downturn and helps your portfolio grow faster with less risk, that is generally the case. By holding a variety of investments that don't perform identically, the idea is that you can get the most return for whatever level of risk you're willing to take.

It's also important to remember that diversification doesn't assure any specific rate of return or asset growth. The actual returns on assets are determined by the markets, and the rate of return your portfolio earns will depend on how you divvy up your money among different investments and how those investments perform.

So while I understand that investors might feel diversification has let them down, I think the problem is more one of unrealistic expectations than any flaw in the concept.