Don't give up on diversification

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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NEW YORK (Money) -- Question: Whatever happened to the supposed benefit of diversification? I diversified broadly - large- and small-cap index funds, foreign shares, corporate bonds, T-bills, even REITs and TIPs. But everything has gone down dramatically over the past year. Doesn't that kill the theory that diversification will moderate the impact of a downturn and help us grow faster with less risk in the long term? I think Peter Lynch had it right when he said most people would be better served by selecting five to seven individual stocks of major companies, instead of diversifying with funds.  Patrick, Rochester Hills, Michigan

Answer: Interesting, isn't it, how quick people have been in this crisis to dump time-honored investing principles? Surf around the net a bit, and you won't have trouble finding any number of people pronouncing the death sentence on buy-and-hold investing, asset allocation, indexing, rebalancing and, of course, diversification.

The usual justification for this revisionism is "this time is different." I'd note that we also heard that rationale back in the go-go 90s when investors decided that concepts like value investing and building a diversified portfolio were passé and that the "new era" way to make money was to put all your dough in shares of dot-com companies that had no earnings.

So I'm skeptical when people are ready to jettison principles that, to my mind at least, are well grounded in the fundamentals of the economy and the markets, not to mention human behavior. I find that people who are eager to abandon principles often don't really understand them, and thus have unrealistic expectations.

In other cases, investment advisers and other pundits may simply be looking to substitute their own set of "new rules" that are supposed to capitalize on today's circumstances (usually by invoking some nonexistent ability to foresee when to move in and out of different assets).

I can't take on all the revisionists in one column. But in the case of diversification, I'll simply paraphrase Mark Twain and say that the reports of its death are greatly exaggerated.

Diversification did work last year, even if it didn't get the investment results you might have preferred.

You see, diversification was never designed to provide a guarantee against losses. No strategy - even sticking to T-bills - can do that.

Rather, the idea behind diversifying is that all your money won't be subject to the fortunes of one investment or asset class. So to the extent you spread your money around, you'll experience a broad spectrum of returns, not a single return on all your money.

Granted, in most years, that spectrum is going to include a much larger selection of positive returns. Last year was an anomaly in that so many different types of investments had a down year.

But if variety of returns is the standard, then diversification still came through. For the 12 months through the first week of April, for example, large-cap U.S. stocks lost about 39%. Foreign stocks as a group lost about 46%. Real estate-related stocks were down about 59%.

Bonds, meanwhile, fared better, although how much better depended on what types of bonds you owned. Because of the flight to quality, government bonds fared best with long-term government bonds gaining over 10%. Not surprisingly, given concerns about the economy and corporate profitability, high-yield junk bonds did the worst, losing about 21%.

I can understand why these figures may not seem like a ringing endorsement for spreading your money around. After all, to the extent you held your money in some sort of equities, you probably took a bath.

The point, though, is that if you diversified, you didn't have all your money in the worst-performing investments. If you had bet on real estate or Latin American stocks, you'd have lost almost 60% over the past year. That's a lot worse than losing 39% in U.S. large caps. And to the extent you diversified into bonds, you had either a much smaller loss or even a small to moderate gain in that part of your portfolio (assuming you didn't go exclusively into junk or long-term Treasuries).

I'm sure some people are saying, oh, but wouldn't I have gotten much more protection than diversification offered if I had simply bought Treasury bills at the beginning of 2008? And the answer is yes, you would have, if you had known in advance what was going to happen. Then again, if you'd known that, you'd have gone to long-term Treasuries, not T-bills, since they outperformed T-bills.

Which brings us to the reason for diversifying: we don't know how different asset classes are going to perform from year to year or even over the longer-term. So to hedge your bets, you spread your money around.

As for your expectation that diversification moderates the impact of a downturn and helps your portfolio grow faster with less risk, that is generally the case. By holding a variety of investments that don't perform identically, the idea is that you can get the most return for whatever level of risk you're willing to take (or, conversely, lower risk for a given level of return).

It's also important to remember that diversification doesn't assure any specific rate of return or asset growth. The actual returns on assets are determined by the markets, and the rate of return your portfolio earns will depend on how you divvy up your money among different investments and how those investments perform.

You can allocate your money sensibly based on the expected long-term returns for different assets and the level of volatility you're willing to accept. But you can't control the actual return you'll get.

I don't know if Peter Lynch actually said that most people would be better off just buying the stock of five to seven major companies than owning a diversified stock fund. After all, this is a guy who ran the Magellan fund that at one point reportedly held upwards of 1,400 stocks. But if he, or anyone else, did say it, I would have to respectfully disagree.

Sure, limiting yourself to a handful of stocks is great if you pick the right ones. But the downside risk is also very high. What if the major companies you had picked a year ago were such titans as Citigroup (C, Fortune 500), GM (GM, Fortune 500), GE (GE, Fortune 500), Bank of America (BAC, Fortune 500), Alcoa (AA, Fortune 500), Caterpillar (CAT, Fortune 500) and energy firm Schlumberger (SLB)? You would be sitting on losses of anywhere from 51% to 90%, as opposed to a loss of 39% in a total stock market index fund or a 22% loss in a 60/40 mix of a total stock market and total bond market index funds.

So while I understand that investors might feel diversification has let them down, I think the problem is more one of unrealistic expectations than any flaw in the concept.

To sum up, diversifying won't lead to the highest return and it can't absolutely assure that you'll get the most return for the least risk.

But it can moderate the swings in your portfolio and give you a good balance of risk and reward.

And until we can accurately predict how different investments and asset classes are going to perform, spreading your money around is the best way I know to participate in the market's long-term gains while dealing with its inherent uncertainties.

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