What Diversification Can Do For You

During 2008, the principle of diversification failed to protect investors from losses as virtually all classes of investments lost money. So what does diversification do for an investor?

What Diversification Can Do for You
The first thing you should know is that it can't guarantee you the highest possible return. In fact, it guarantees you won't earn the highest possible return. By spreading your money around you assure that you will have at least some of your money in lagging investments, which will reduce your portfolio's potential return.
By the same token, diversification can't totally immunize you from losses. To do that, you would have to do the opposite of diversifying -- i.e., plow all your money into the most secure investments, such as Treasury bills or short-term bank CDs.
What diversification can do for you, though, is give you a shot at higher returns than you will get in the most secure investments while limiting your risk somewhat.
Notice I said "somewhat." Fact is, if you want the value of your money to grow more than it will in T-bills and the like, you've got to invest in asset classes that have the potential for higher long-term returns, such as stocks and bonds. But those higher returns come with more risk. In the investment world, that risk can take several forms, but generally the riskier an investment, the more volatile it is, the more its value will jump around from year to year.
You can't eliminate that risk. But by investing your money in a mix of secure and more volatile assets, you can reduce the potential downside in a given year. For example, if you'd had all your money in a diversified portfolio of U.S. stocks last year, you'd have lost just under 40%. If, on the other hand, you'd had 60% of your money in stocks, 30% in a broad bond index fund and 10% in cash last year, you would have lost roughly half that amount, or around 20%.(See editor's note.)
That kind of cushion is important for a couple of reasons. For one thing, it makes you less likely to panic in a bad year and sell off riskier investments with higher long-term return potential at what may be the worst possible time. A less volatile portfolio is also less likely to take a devastating hit that may be difficult to recover from. That's an especially important consideration when you're dealing with 401(k)s or other retirement accounts and you're nearing retirement age or are already retired and withdrawing money from such accounts.
So the key to getting the benefit of diversification is settling on a mix that's right for you.
Ideally, your mix should consist of assets that don't all move in sync with each other or, to put it in investing terms, that aren't too highly correlated with each other.
It's okay for gains in some investments to offset losses in others in some years. But on balance your gains should outweigh losses most years. And, while down years are inevitable with growth-oriented investments, whatever assets you're investing in should have a positive long-term return. Diversification isn't a magic formula that can turn recurring sizeable losses in your investments or your portfolio overall into long-term wealth.

What Diversification Can't Do for You
But as big an advocate as I am of diversifying among a variety of asset classes, I also feel that the concept has been stretched out of shape over the years, in some cases even beyond recognition.
Specifically, I think the benefits of diversifying have been oversold by some advisers who seem intent on making themselves come off like investment wizards capable of creating all-upside-no-downside portfolios. But I'm wary of these supposedly more sophisticated portfolios.
So I suggest keeping things simple. Start with a realistic sense of how much risk you can handle and then build a diversified portfolio of stocks, bonds and cash. If you want to get more fancy, you can throw in some foreign stock funds and maybe some REITs or real estate-related mutual funds. But don't go overboard. The more complicated your portfolio is and the more wide-flung your holdings, the more attention and care it will need.
Finally, remember that to get the full benefit of diversifying you ought to rebalance periodically to restore your portfolio to its proper proportions.
Of course, you can always take the other route you suggest and just buy CDs. But unless you have so much money that you can accumulate a large enough nest egg despite their low yields, I'm not sure that you can do this and also not worry.

Biblical Perspective on Diversification

What does the Bible teach on the importance of diversification for your investment portfolio. The best verse on this topic is Ecclesiastes 11:2.

"Give portions to seven, yes to eight, for you do not know what disaster may come upon the land."

This verse states that nobody can not predict the future and can not predict when an investment will run into a problem. Since we do not know the future the best way to keep you portfolio on a more even keel and in the correct direction is to diversify into 7 or 8 investments rather than have a single investment.

In today's terms this has been called Modern Portfolio Theory. Here are some specifics on this theory.

• Harry Markowitz won Nobel Peace Prize in Economics in 1990 for his theory published in 1950.
• Principal of Co-Variance: Risky higher returning investments, each having their own variance, when combined in certain amounts will have an overall lower amount of risk and maintain higher returns.
• Example: Blend of International and US Equities give a better return and lower risk than just US Equities alone.
• Why is this important? Because money moves between stocks and bonds and between different parts of the world.

A Nobel Peace Prize winner has proven that what the Bible documents makes really good sense.

Stocks or Mutual Funds

An investor has an option when it comes to buying equities, individual stocks are a mutual fund that contains a group of stocks. The mutual fund gives diversification in a variety of stocks. An individual stock has no diversification and has considerable more risk because it has unlimited upside potential and can theoretically go to $0.00. For the savvy investor which one is best an individual stock or a Mutual Fund? My answer is a mutual fund.

Reasons to Own a Mutual Fund

While a stock has considerable risk a belief seems to exist that a person can get sufficient information to know when to buy or sell it. I think this is absolutely false. Let's look at the events around General Electric, GE on Friday, April 11th.

Certainly GE has been a darling on Wall Street. On Friday, April 11th, GE announced earnings. Let's go through the sequence of events:

• The belief on Wall Street was that earnings would be good and reasons were given by the experts that make a lot of money giving investor advice.
• Earnings missed expectations and a positive spin was put on the results.
• By the end of the day the stock dropped 13%, the worst 1 day decline since the 1987 market crash. This fact came from Barron's April 14, 2008 publication.
• Barron's wrote a wonderful article in this publication, "At GE, One Bad Quarter Doesn't Spoil the Story" by Andrew Bary

The questions are:

1. What would you have done if you would have listened to the advice prior to the earning announcement? Lost 13%.
2. Why would Barron's publish the article? To sell more publications.
3. Why would Andrew Bary write the article? To make money.
4. Do people at Barron's or Andrew Bary own GE stock? Most likely.

Bottom Line: Are you getting the total unbiased information from these experts? No. If these experts can't get it right on GE, what makes you believe they will get it right on any stock that you own.