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WALL STREET, CALIFORNIA | INVESTING 101 / KATHY M.
KRISTOF

Diversify to Reduce Risk : Protecting Yourself Isn't a Matter of How Many, but of How Different

10 Things Every Investor Needs to Know: 2. How to diversify to reduce risk

November 05, 1996|Kathy M. Kristof

Greta thought she was following sound financial practice by spreading her investments among more than a dozen mutual funds. She reasoned her portfolio would be diversified enough to reduce the risk of loss.

But when the value of small-company stocks took a dive in summer, so did Greta's whole portfolio. It turned out that most of her mutual funds were invested in small-company stocks.

Greta learned a lesson worth sharing with all investors: Having a lot of investments does not necessarily make your portfolio diversified. For diversity, you need several different types of investments.

"It is important to look at the structure of your portfolio and the types of companies that are in it," says Patricia Johnson, vice president at Smith Barney Inc. "If you are buying all pharmaceutical stocks or all technology stocks or all international stocks, you are not diversifying," no matter how many different company--or mutual fund--shares you buy.

The purpose of diversification is to protect your overall portfolio from major shocks. Because different markets tend to move at different times--one type of investment may be moving up in value while another is moving down--having a variety of investments lends stability to a portfolio.

Diversification, however, can also reduce your overall return--as does any strategy that reduces risk (as we learned in Lesson 1 in this tutorial series).

A portfolio of 100% big-company stocks has gained about 10.5% annually, on average, since 1926, whereas a portfolio that is half stocks and half government bonds has returned 8.4%. In terms of total wealth over a long time, that difference is substantial. Invest $10,000 in an investment returning 8.4%, leave it for 30 years and you'll have $123,199. Invest that money at 10.5% and you'll have nearly twice as much: $230,185.

The trick to diversification is doing just enough to allow yourself to sleep--and meet near-term goals--without doing so much that you rob yourself of generous long-term returns.

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How to do it? Start by creating a list of what you want to accomplish with your money and when you want to accomplish it. Then divide your investments into "baskets" aimed at meeting each goal. Finally, determine how much volatility you can handle with the money set aside to meet each goal.

For instance, you are likely to have a host of short- and long-term goals. You may, for example, want an emergency fund that can be tapped if you lose your job or have a large unexpected expense; a college fund for your toddlers; and a retirement fund for you and your spouse.

Each of those goals has a different anticipated cost and different time horizon. If you have a stable job and no large and looming financial obligations, the emergency fund is likely to be modest--probably 5% or less of your total investment portfolio. However, you may need it at a moment's notice.

For that reason, it's probably best invested in cash equivalents: money market accounts, Treasury bills and short-term bank deposits. These instruments offer lackluster long-term returns, but they also don't exhibit short-term swings in value. So your money is there if you need it in a hurry.

However, if you and your children are relatively young, you've probably got a long time before you'll need the college fund or the retirement savings. Consequently, those baskets are the natural place for stock investments, because you should be able to ride through short-term swings in the market in order to reap more generous long-term returns.

But should all of your long-term money be invested in stocks? Probably not. Although stocks have been the best asset class in the very long run, the market experiences some deep slides periodically, with the result that investors temporarily lose significant percentages of their wealth. Recovering those losses can take several years.

If you were forced to sell a portion of your stock portfolio during those lean years, it would have a negative effect on your wealth in the long run. So most financial advisors suggest that long-term investment baskets include some bonds and other non-stock assets, such as real estate, that add diversity and thus buffer against stocks' periodic losses.

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Exactly how should you divide your retirement or college-savings portfolio among stocks, bonds, cash and other assets? Only you can decide. However, your decision may be easier if you consider some historic return and risk data compiled by Ibbotson Associates, a market research and consulting firm in Chicago.

As noted earlier, a portfolio 100% invested in big-company stocks earned 10.5% annually on average from 1926 to 1996. That portfolio lost money in 20 years out of 70. The average loss in those bad years was about 10%, and the worst annual loss was just over 43%.

Meanwhile, a portfolio invested 80% in stocks and 20% in bonds has historically returned 9.8% on average. That portfolio lost money in 19 of 70 years. But the worst annual loss was 36%, significantly less than the all-stocks portfolio.

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