We can still vividly recall the pointed questions in the late 1990s regarding diversified approaches: "Why do foreign stocks make sense?", "Why are alternative asset classes worth the trouble?" and "Why should endowment funds hold bonds?" were among the most common inquiries. These were not easy questions to answer as the incredible success of large capitalization growth stocks during just a few short years appeared to undo decades of history in support of the notion that better returns with less risk could be earned by pursuing a diversified approach.
Moving beyond returns themselves, the fact is that it doesn't take long for investors to fall prey to the overconfidence that pushes risks of any form quickly to the back seat. The quintessential expression of this attitude appeared in a major business magazine article back in 2000 that effectively referred to those who pursue diversified approaches as incompetent and foolish (the article actually used harsher language than this).
Included among the important ideas that were lost during this period was a longer term perspective on returns along with the knowledge that markets are cyclical and that conditions would unexpectedly change.
Controlling and managing risk is exceptionally important for endowed funds as they must be allocated heavily to fairly risky asset classes in order to have a solid opportunity to preserve purchasing power. Late 1990s "weakness" in relative returns for some of these funds was not the product of an inferior strategy, but was instead caused by reduced risk created via broad diversification. This, of course, became quite apparent in the years that followed and led to the new set of mistakes we are seeing today.
As we enter 2006, the benefits of d ...