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The right mix
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December 26, 2001: 6:15 p.m. ET
There's more to managing your risk than simple diversification.
By Michael Sivy
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NEW YORK (CNN/Money) - I'll be writing chiefly for MONEY Magazine in 2002, so this online column will cease at the end of the year. I'd like to devote the last three columns to some general observations about investing. Today, I'll discuss some questions about diversification. On Friday, I'll look at the issue of sustainable growth. And next Monday, I'll size up the economic outlook for the coming decade.
There are more ways to diversify than most investors realize -- what they have in common is that they protect you against the dangers that you can't anticipate. All investing is a tradeoff between the risks you take and the returns you can hope to earn. These risks can be reduced but not eliminated. Everything investors can know with a high degree of certainty is already reflected in the market price of an investment. So the factors that make prices go up or down often can't be gauged beforehand. Protecting yourself against the things you can't know is the most important part of managing risk.
This inescapable uncertainty isn't the only problem investors face. Most people expect the future to be similar to the past and tend to underestimate the potential magnitude of changes. As a result, investors often price stocks incorrectly, overpaying for those that are risky and flashy and undervaluing safe investments that are dull.
Protecting your portfolio
There are some dangers that you can anticipate -- at least to a certain extent. Sometimes a trend can't continue because the economic fundamentals won't sustain it. In retrospect, for instance, it's clear that the Internet boom couldn't go on forever because many of the companies were spending investment capital they had raised rather than cash flow generated by their businesses. Sooner or later, the investment capital had to run out and the boom had to end. Other times, you can be alerted to potential economic reversals by looking at historical patterns. In my previous column, I talked about the threat of resurgent inflation and what you can do to forestall it.
You should recognize, though, that you can't foresee everything. Once you've done what you can to guard against the threats you can anticipate, the only other step you can take to safeguard your money is to diversify as broadly as possible. Most investors are familiar with the simplest type of diversification -- owning a variety of stocks, for instance, so that you don't have all your eggs in one basket. But there's more to diversification than just buying a bunch of stuff.
Understanding diversification
The first principle of diversification is that you need to own investments that react differently to economic changes. Since you can't anticipate what is going to happen next, you want to ensure that not all your investments will take a direct hit from some negative development. Balance an oil stock with an airline, for instance, and whether the prices of oil and jet fuel move up or down, at least one of your stocks will benefit. The same principle is true for market sectors. Value stocks counterbalance growth stocks. And even among growth stocks, health care will hedge tech to some extent.
There are, however, more sophisticated forms of diversification. One is to consider a company's business mix. Firms that have a variety of successful products will always be safer than those dependent on just a handful of product lines. American Home Products and Johnson & Johnson, for instance, are inherently less risky than Amgen, which makes the bulk of its profits from only two drugs. Amgen recognizes that weakness and is currently trying to acquire a third important drug through a merger.
There's another important type of diversification, although many investors don't think of it in those terms. Because the market's behavior is so unpredictable, you should try to buy or sell investments at several different points in time. In fact, diversification over time turns out to reduce your risk even more than diversification among investments.
The simplest form of diversification over time is the strategy known as dollar-cost averaging, where you add a certain amount of money to a mutual fund at regular intervals -- $100 a month, for instance. Dollar-cost averaging ensures that you don't put in all your money at the top and also enables you to buy more shares when prices are depressed, thereby reducing your average purchase price. This strategy also makes sense if you're withdrawing money from a mutual fund -- take it out in a number of payments at regular intervals.
You can also use more sophisticated versions of diversification over time if you're buying or selling stocks in a portfolio. Recognize that your true goal isn't to catch the exact bottom or top. Rather, you should spread out your purchases or sales so that you diversify your exposure to the market and thereby reduce your overall risk. Once you get used to thinking in terms of diversification over time, you'll start to view the market differently -- and you'll see portfolio strategy in another light.
If you're consciously trying to diversify over time, you won't waste a lot of energy trying to call market turns. Instead, you'll look for opportunities to shift money little by little from sectors that appear generally overpriced to those that seem undervalued. In a bad bear market like this one, you should try to protect yourself by investing defensively and maintaining larger-than-usual cash holdings.
But it's equally important to remember that for long-term investors (as opposed to traders), bear markets are times of opportunity. This is the time to be building the portfolio positions that will earn superior returns over the coming five or six years. Don't worry about catching the exact bottom. Don't worry about calling the turn. Just make sure that you've got a well-balanced and defensive portfolio set up before the recovery really gets going. Once a rebound starts, the profits will take care of themselves.
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