The Wise Investor’s Mantra: Diversify, Diversify, Diversify

by | Apr 18, 2008 | Cash Flow, Weekly Column

living-under-a-rock.jpgUnless you’ve been living under a rock, you probably know these are not happy times for investors. A casual glance at the financial headlines would lead to the conclusion that the best place to put your money may be under your mattress—preferably in euros.

A recent front page story in The Wall Street Journal led with a story about a couple who planned to retire this year, but now can’t because of the failing economy. Instead of quitting their jobs and retiring to sunny Arizona, they will continue to work because they can’t sell their home and have suffered a 20% decline in the value of their retirement plan. The story went on to talk about how bad things are for investors.

Reporting like this really gets my goat. While I am sure the reporter’s facts are right, the story would lead casual readers to conclude that the average investor has lost 20% so far this year. What the reporter didn’t mention was that this particular couple must have taken a very concentrated position on a handful of stocks or a few specific sectors.

Let me explain. At the time this story was written, the S&P 500 was down no more than 14%. The S&P 500 is an index, representing an investment in the 500 largest US companies. Because this couple’s retirement funds did much worse than the S&P 500, they could not have been diversified, even in stocks. That’s the story the reporter omitted. Had this couple understood the safety and power of investing in a diversified portfolio of asset classes, they probably would be retired today.

A diversified portfolio will not have more than about 40% in the US stock market. It will also have international diversify.jpgstocks, high quality bonds, junk bonds, TIPs bonds, commodity funds, REITS, and market neutral funds. Investors who are diversified among five or more asset classes have seen very minimal losses this year. I would guess that the average diversified portfolio had very small or no losses during the first quarter of this year. That’s a far cry from the poor couple who lost 20%.

It still amazes me that asset class diversification is the exception rather than the norm. Of the hundreds of portfolios I’ve seen over the past 25 years, maybe 1% had any type of serious asset class diversification. That’s sad in a day and age where extensive investment knowledge is available to anyone with access to the Internet.

If history is any predictor of the future, and I’ll bet it is, we are probably nearing a market bottom and the worst is behind us. I base that on several factors. First, the average recession since 1945 has lasted 11 to 16 months. Most bear markets bottom around the sixth to ninth month of the recession, meaning we should see a market bottom around May to July.

Second, I am hearing and reading about more and more investors starting to panic and switching from stocks to bonds or cash. My experience is that investors, left to their own means, typically sell-out or buy-in at precisely the wrong time. I call this “the big mistake.”

This market decline will be no different, mark my words. Just at the time things look the darkest for the economy, hordes of investors will decide to fold their tents and sell-out. Soon after that diversified-pie-chart.jpgsell-off, the market will bottom and start its bumpy march upward; leaving behind those who panicked and sold out.

So what’s the cure to getting through times like this? Diversify your portfolio in five or more asset classes, set your allocations, and sit back and relax.

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