In our March update to our investment advisory clients, we included an article titled “Did Asset Allocation Fail Investors in 2008?”. In that article we quoted Robert Arnott, Chairman and founder of Research Affiliates and manager of two PIMCO mutual funds. In a Morningstar® internet video, Mr. Arnott said that in market crashes, correlations between asset classes soar. He said “that you have a flight to quality, a flight to liquidity and a flight away from unfamiliarity.” That affects nearly all investments, with the exception of Treasury securities, which did well in 2008.

One easy lesson to draw from 2008, Mr. Arnott said, is to assume that you should not count on diversification, that you should take less risk. “That’s the wrong lesson to take” he said because what we saw in 2008 was probably a “once in a career” event and that structuring our investment strategy on an event that we will likely never experience again is dangerous. Mr. Arnott said “that the correct lesson to take form this experience is to step up your risk if you weren’t already taking too much risk”.

At the time of this writing, the Wall Street Journal had just published an article discussing this same issue titled: “Failure of Fail-Safe Strategy Sends Investors Scrambling” (July 10, 2009). The article noted that the financial crisis has caused many financial advisors to rethink their asset allocation strategy. Some argue that asset-allocation strategies are inherently flawed. The article noted that Fidelity Investments disagreed: “ Diversification didn’t fail in the recent market downturn. It worked – just to a lesser degree.”

Our view is that in extreme market downturns such as we have just experienced, asset allocation will not be as effective. Nevertheless, all asset classes did not experience the same level of losses. Bond funds, in general, suffered less. Therefore, we believe, a diversified portfolio made up of a broad collection of diverse asset classes will help minimize losses.

An obvious question is: What’s the alternative? If you try to pick one or two asset classes that will do the best, it’s very tough to do. Besides, we believe that in more normal markets, asset allocation still works. Many asset class returns are not highly correlated in up markets. And even though U.S. and international returns seem to be more closely correlated, investing in both markets helps reduce currency risk.

Market returns so far this year are proof that various asset returns are uncorrelated. Small stocks have outperformed large stocks, international stocks are doing better than U.S. stocks and bonds in general are doing much better than stocks. In the 2000 tech stock debacle, small stocks and REITs performed very well while U.S and international stocks crashed.

So what’s the bottom line? While it does appear that the world is getting smaller and the various asset class returns are somewhat more closely correlated, we still have confidence that asset allocation makes sense for the average investor.