Diversifying investments is still a critical strategy

The Dallas Morning News (MCT) - It's one of the fundamental tenets of financial planning: Diversify your investments.

Or, as your mother would say, "Don't put all your eggs in one basket."

In theory, you can reduce risk in your investment portfolio by combining a variety of investments that aren't likely to all move in the same direction.

It's a good theory, but one that has been tested by the recent financial meltdown in which stocks, bonds, commodities and real estate have all had their ups and downs _ though mostly downs.

So, given the current economy, should you abandon diversification as a strategy?

Not by a long shot.

"It would be a mistake for investors to look back on a single year and dismiss an idea that has worked generally quite well over time," said Christine Benz, director of personal finance at Chicago-based Morningstar Inc., an investment research firm.

However, the gut punch to the economy does highlight the limits of diversification, said Stephen Horan, head of professional education content and private wealth at the CFA Institute, an organization of financial analysts, based in Charlottesville, Va.

"Diversification works when markets are going up," he said. "But when you have an economic shock, everything moves in the same direction."

Still, he's convinced diversification is critical to a sound investment plan.

So is Michael Busch, president of Vogel Financial Advisors LLC in Dallas.

"Diversification has been getting a bad rap lately," Busch said. "There seems to be a common misconception that diversification didn't work in this market."

People feel that way, he said, because "there were no safe havens" in the market.

But Busch adds: "Just because diversification didn't work as well as it has in some down markets, doesn't mean it didn't work at all.

"After all, would somebody have wanted to be undiversified in financial stocks last year?"

Diversification still works, agreed Brian Bruce, director of the ENCAP Investments & LCM Group Alternative Asset Management Center at Southern Methodist University's Cox School of Business.

"In 2008, if half your portfolio was in fixed income (bonds), you should have done reasonably well," he said.

Indeed, U.S. Treasury securities were one of the few bright spots last year as investors sought shelter from plummeting stocks.

Consider that the Barclays Capital 7-10 Year U.S. Treasury Index soared 18 percent in 2008. In contrast, Standard & Poor's 500 stock index fell 38.5 percent, and the Dow Jones industrial average skidded 33.8 percent.

There are really two steps to diversifying your investments. The first involves "asset allocation" in which you divvy up your investments among asset classes, such as stocks, bonds and cash.

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The next step is to drill more deeply and spread your money among different investments within each asset category.

"It is important to be diversified not only among the broad asset classes _ your asset allocation _ but also within asset classes," Busch said. "You want to first determine an appropriate mix of stocks, bonds and cash, and then you also want to establish a mix within each asset class."

For example, you might diversify your stock investments by choosing both domestic and international stocks, large- and small-capitalization stocks, or growth and value stocks.

You should also spread your stocks among different industries and market sectors.

"If you invest in individual stocks, just think of the damage to your financial future if you had held mostly Bear Stearns stock," said Mark W. Riepe, senior vice president at the Schwab Center for Financial Research.

"Because there are so many things that can go wrong with a particular company, we believe it just doesn't make sense to have more than 10 percent of your portfolio in any one stock."

With bonds, you might select different types with staggered maturity dates, or invest in both government and corporate bonds.

Your goal is to ensure that your investments don't rely too heavily on what happens to a single stock or bond.

In the end, investors need to approach diversification from a different perspective than in the past, Busch said.

"Hopefully, people will understand better now that diversification doesn't eliminate risk; it just reduces it," Busch said.

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© 2009, The Dallas Morning News.