Sudip Bandyopadhyay’s Blog

Diversify. That was the mantra investors heard in recent years. Investing in a range of assets was supposed to improve overall returns as these were uncorrelated bets.

This year world stock markets lost almost $ 30,000 bn in value. Oil prices fell by two-thirds. House prices dropped. Bonds – except for government bonds – collapsed. And poor November sales at Christies and Sotheby’s showed the art market turning too. Almost every asset performed the same in 2008: it went down. This was unusual. Normally assets have their moment in the investment sun depending on the stage of the economic cycle. Bonds and defensive stocks, such as utilities, perform well going into a recession. Growth stocks do best coming out. So-called emotional assets, such as paintings, supposedly have no link to the economic cycle at all. This year everything happened simultaneously. Correlations converged on one. Why was this? The proximate reason was diversification itself – often into hedge funds. At the peak, these controlled about $2,000 bn of equity. Leveraged three times that provided some $ 6,000bn of spending power. And they invested in everything from common equities to convertible bonds to rare guitars. The problem was that, while these assets are heterogeneous, the owners were not. In tough times they behaved the same way. They sold. It is unfair, however, solely to blame hedge funds. They were only a manifestation of a broader phenomenon – leverage. Money markets that provided that debt were already struggling in 2007, when British bank Northern Rock went down. They froze after Lehman collapsed . That is why asset prices collapsed, so fast afterwards.The trough of cheap money used to purchase assets suddenly emptied. Diversification was therefore fake. That made for a terrible investment year in 2008. The good news – if that deleveraging process is over – is it could make for a happier 2009.