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Mutual Funds > Mail Bag
In defense of diversification
July 28, 1999

Zweig answers critics who wonder why anyone would possibly want to invest in anything other than U.S. stocks.
By Jason Zweig
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[Editor's note: Jason Zweig has received several e-mails criticizing the contention in his August column that diversification is a good idea. Here's a sample, plus his resp onse.]

Jason,
What do you have to back up your "invest in everything" dogma that [advocates] buying foreign and domestic stocks and bonds? The world has finally settled down since WWII, and the US came out on top. The last few years have proven that we can survive wh ile the world is weak. All an investor needs is a well diversified US fund. I believe that this will beat the "buy everything and it is bound to go up" philosophy.
Brian Martin
wbmartin@gateway.net

Dear Brian:
If long-term investing were exclusively about maximizing returns, you might be right. But investing is also about minimizing risk. Your argument that the U.S. is on top of the world is precisely what the "experts" were saying about Japan ten years ago. Before long, we were told, we would all be eating sushi for breakfast whether we wanted to or not. Now I don't know about you, Brian, but I ate a bagel this morning, and I rather enjoyed it. And ever since all the experts agreed that Japan's economy wo uld dominate the world for decades to come, the Japanese stock market has lost more than half its value.

Now I'm not saying the same thing is going to happen in the U.S. But the next time you meet an experienced Japanese individual investor, I think you should ask him whether he thinks investing outside one's own stock market is a bad idea!

To take another example, many investors may be asking why anyone would want to own bonds. First off, stocks are not anti-gravity machines; someday (and no, I don't know when), they will stop going up. They might do nothing for a decade or more, or they might lose 40% of their value. With stocks, anything is possible, as this chart from research firm Ibbotson shows. Meanwhile, Uncle Sam guarantees that he will double your money in 12 years--this 6% return, at absolutely zero risk, sounds like chickenfeed now, but it will seem like pure platinum when stocks stop going up.

Second, bond returns have matched or beaten stock returns for surprisingly long periods, 1966 through 1982 being just one example.

Third, bonds have tended to do well when stocks (and individuals' salary growth) do poorly. For example, in 1990, when the S&P 500 lost 3.2%, medium-term Treasury bonds gained 9.7%, while in 1973-1974, when blue chips lost a mindblowing total of 37%, bond s returned 10.6%.

Finally, the probability that stocks will outperform bonds, even for periods of 20 years or more, is not 100%; in fact, depending on valuations and volatility, that probability can go below 50%.

In short, we simply do not, and cannot, ever know exactly what the future will hold. Betting everything on a single kind of asset (like the U.S. stock market) is not much wiser than betting everything on a single stock (like Cendant or Iomega, or even Mi crosoft). Yes, it's always possible that U.S. stocks will pummel everything else until the end of time. It may even be probable. But it is far, far from certain.

Since you already live in the U.S., earn your salary in dollars, and pay your mortgage with dollars, do you really want to tie up 100% of your financial assets in the U.S. stock market? You are taking a multi-layered gamble that no other investment will do as well. If you turn out to be wrong, what will you use to cover your downside--and your backside?

Personally, I am delighted to keep roughly 20% of my portfolio in bonds, and more than 25% in foreign stock funds. To me, the best definition of investment risk is the chance that when all is said and done, with the gift of 20-20 hindsight, I will regre t my choices. And decades from now, when you and I both are taking our teeth out at night, which risk will feel worse: looking back and feeling we made less money than we could have, or looking back and feeling that we *lost* more money than we should ha ve? I'd rather take the first risk; if you prefer the second, I wish you the best of luck.

Write to Jason Zweig at fundamentalist@moneymail.com






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