Personal Finance


April 24, 2009

December 17, 2010

Diversify your investments even if it hurts

Everything you thought you knew about diversification is wrong. So is everything you thought you knew about portfolio risk. It took the meltdown of September and October 2008 to flesh out the story, but the plot outlines have been in place since the 2000 tech-stock bust.

The measure of stock-market risk typically focuses on your holding period. The longer you hold a portfolio of diversified stocks, the less likely your chance of losing money over the entire term.

The classic example is the record of the Standard & Poor's 500 Index. Over rolling monthly five-year periods since 1926, it lost money 14 percent of the time, with dividends reinvested, according to Ibbotson Associates in Chicago, which publishes market data. Over 10-year periods, it lost money 4 percent of the time. Over 15-year periods there have been no losses at all. (The most recent 15 years delivered a 6.5 percent annual gain.)

With data like this, stocks for the long run, plus reinvested dividends, still look like a safe bet.

But it's a mistake to focus only on your investment’s theoretical ending date, says money manager Mark Kritzman, chief executive officer of Windham Capital Management in Cambridge, Mass. You’re assuming that you will be able to withstand market crashes prior to that date, which may not be the case. On the way to its (presumed) positive long-term result, your portfolio might suffer several declines of 20 percent or more.

The longer you hold, the more likely it is that such a fall will occur, Kritzman says. Looked at that way, your stock market investment grows riskier, not safer, with time. One of those retreats might drive you out of stocks entirely, or force you to lower your stock allocation to protect the money that remains.

Hedging risk

How do you hedge against that risk? That's where diversification comes in. But the usual advice on how to diversify hasn’t protected you very well.

Effective diversification depends on correlation -- a statistical measure of how two assets move in relation to each other.

Assets that produce similar returns are highly correlated. An example would be large growth stocks and an S&P 500 index fund. You get some diversification when you own them both but not a lot.

Assets with low correlations move in the same direction, up or down, but at different rates. If one asset falls a lot in price the other might fall just a little. Assets with negative correlations move differently. When one of them produces returns that are above average, the other's returns tend to fall below average.

Appeal of opposites

The best way to minimize your risk of investment loss is to own assets with low or negative correlations. The problem is that correlations change. The standard measures may be effective over full market cycles but not for the occasional, turbulent markets that come along.

As an example, take large U.S. stocks versus emerging-market stocks. The usual measures show them to have a low correlation. As a diversifier, they should reduce your risk and increase returns. If you hold for 15 years, they probably do.

As you may have noticed, however, emerging market stocks got killed last year. The MSCI Emerging Markets Index dropped 53 percent from January to November, 2008, compared with 33 percent for the S&P 500. Just when you needed protection the most, your diversifier not only failed but dragged you down more.

The same thing happened if you bought smaller stocks as a diversification against larger stocks, or bought value stocks to diversify a growth portfolio. When stock prices fall, the correlations between these sets of assets rise. Thatís a fancy way of saying that, in down markets, all types of stock investments die at once.

Crisis time

This isn't new, says Larry Swedroe, a principal in Buckingham Asset Management in St. Louis. All risky assets, U.S. and international, declined together during the recession of 1973-74 and again in the summer of 1998, when a collapse in Southeast Asian economies sped around the world. In times of crisis, they correlate highly, and always have.

To limit your risk, you have to pay more attention to asset classes that diversify in a slump, Swedroe says. These include cash, very high-quality corporate and municipal bonds, Treasuries (including Treasury inflation-protected securities, or TIPs), governments and (often) commodities. Together, they might slow the expected future growth of your total portfolio. More important, they help you maintain a minimum level of wealth so you won't be forced to lower your standard of living.

No hiding

You might object that, last September and October, bonds and commodities fell, too. Nothing was safe except cash and Treasury securities.

But you can't form a long-term investment policy on a “unique, non-recurring episode,” Kritzman says. (At least we hope it’s non-recurring.)

Some investors wonder whether they should even bother diversifying their equity portfolios if all types of stocks go down at once. Answer: yes. The proof, again, lies in emerging-market stocks. Since November, they're up 12 percent, compared with a 13 percent drop for the S&P 500.

On the upside, some markets rise faster than others, so you want to own them all. Diversification protects you against the risk of picking the single equity market that lags behind.

Here's Kritzman’s optimal portfolio for individuals today: 20 percent U.S. stocks, 15 percent international stocks; 20 percent money markets; 8 percent commodities; 4 percent U.S. real-estate investment trusts; 2 percent international REITs; 6 percent long-term Treasury bonds; 5 percent intermediate Treasuries; 5 percent TIPs; 5 percent corporate bonds; and 10 percent international bonds. His wrap-up advice: Buy these markets with index funds.

Bryant Quinn, a leading personal finance writer and author of “Smart and Simple Financial Strategies for Busy People,” is a Bloomberg News columnist. She is a director of Bloomberg LP, parent of Bloomberg News.


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