Markets & Finance

The Joys of Diversification


By Kathleen Turner Starr Q: Given the market's performance in the last several months, I'm hearing more and more about diversification. What does it mean and how would I go about doing it? -- J.P., Hudsonville, Mich.

A:On the face of it, portfolio diversification ought to be simple: You don't put all your investing eggs in one basket because if you drop it, or if your money manager drops it, all the eggs will break.

But it's not that easy. Suppose you don't invest all your available capital in one stock. Suppose you buy two. Are two baskets enough? And which eggs go in which baskets? Does your IRA money go into Old Economy stocks and your extra savings go into tech stocks? No, not so simple indeed. But it's important to figure out because diversification allows investors to reduce risk in their portfolios without giving up any return.

This is not to say that diversification reduces investment risk to zero. Anytime you buy a stock or bond, you take the risk that you may not achieve your expected return. Portfolio diversification reduces the risk that is unique to a given security and leaves you with the risks that are common to all financial instruments. You can't get rid of common, or systematic, risk. But by diversifying your overall investment portfolio, you minimize your exposure to individual securities' risks and decrease the volatility of your returns. That's a lesson that investors who risked all their money on dot-coms may have learned too late.

MANAGING RISK. Diversification comes into play after an investor identifies his or her risk/return objectives and decides on the portfolio's broad asset allocation among stocks, bonds, and cash. Within this framework, the goal is to identify securities that will contribute to the return objective while minimizing risk. Two stocks are almost always less risky than one. If one of them tanks, the other still has a chance to keep your portfolio afloat. Owning three securities further increases the likelihood that at least one of them will be going up while the others go down. The rule of thumb is that it takes a collection of 30 to 40 stocks to really reduce the risk of a given portfolio.

However, even a grouping of stocks like the 30 issues in the Dow Jones Industrial Average (DJIA) -- or the broader-based S&P 500 index -- is not immune to common risk. During the current economic slowdown, the Dow, the S&P 500 and the tech-laden Nasdaq Composite index all dropped into bear market territory, regardless of the specific earnings prospects or credit ratings of the individual companies that make up these indexes. By the end of March 2001, if you were invested in broad-based equities, most of your investing eggs, battered by the market's violent swings, were probably cracked -- even if you had put them in many different baskets.

If you're stuck with common risk, at least you can do something about unique risk -- also known as "security selection" risk or "unsystematic risk." It's the risk involved in owning a particular security and the idiosyncrasies that come with it, such as the company's business risk, financial health, sector performance, management structure, etc. A good example is Ford Motor Co.'s (F) Firestone fiasco. General Motors' (GM) stock doesn't tank when Ford has a tire recall, although it may well dive for other reasons.

THE RIGHT MIX. Merely owning many different securities, however, does not a well-diversified portfolio make. The key to diversification is to own types of securities that move in different directions so that when one is going down, another is likely to be going up. "The most important thing to understand is that the more correlated the assets are, the more volatile [read risky] the portfolio will be," says Doug Wilde Vice President and Global Investment Strategist at Merrill Lynch. The success of diversification depends on what kind of correlation -- i.e., how the investment types typically move in relation to one another -- exists between the portfolio components.

There are lots of ways investments can correlate -- by asset class, geography, company size, industry sector, or investment style such as growth vs. value. Not every dimension offers the same amount of diversification potential. For instance, Wilde's research shows that, in the last seven years, the correlation between the S&P 500 and international stocks has gone from 20% to about 75%. That means they move in the same direction about 75% of the time. In contrast, the correlation between the S&P 500 and domestic bonds has diminished. Moving together about 60% of the time in 1994, in recent months the asset classes have started to be negatively correlated, actually moving in opposite directions. That means from a diversification point of view, bonds offer more opportunity to reduce S&P 500 risk than international equities.

Before dumping your international equities for bonds, however, consider your asset allocation strategy. The balance between stocks and bonds could well reflect your investment return objectives. If that's the case, but you have too much of the equity portion of your portfolio concentrated in the S&P 500, or some other index, you might consider buying an alternative equity investment such as real estate investment trusts (REITs).

MUTUAL BENEFIT. Crunching correlation coefficients is no fun (for most of us anyway), but you can avoid the necessity for doing it yourself by buying mutual funds. "Get started by investing in a broadly diversified fund that invests across asset classes and, after you have a little more experience, another way to approach it is to buy sector funds," recommends Stephen Mitchell, Senior Vice President of Product Management & Development at Fidelity. Fidelity has an online portfolio analysis tool that will assess the level of diversification in your portfolio. One thing to watch is that mutual funds own many of the same securities, says Mitchell. Be sure to look at your funds' individual holdings as you examine the level of diversification in your overall investment portfolio.

Whether you do it yourself, or let mutual funds do it for you, it doesn't cost extra to diversify. And you should end up with enough eggs at the end of the day to make a poultry farmer jealous.

Do you ever get the feeling you could be doing something a lot smarter with your money? Do you know how to navigate the tricky currents of home-equity loans and mortgages? Ever worry about whether you've got the right insurance, or if your accountant is minimizing your tax bite as much as possible?

If you'd like the answers to these and other questions about your personal finances, shoot an e-mail to Ask_Katie@businessweek.com, or send a letter to Ask Katie, Business Week Online, 6th Floor, 2 Penn Plaza, New York, NY 10121.

Please include your real name and phone number in case we need more information. If we use your question, only your initials and city will be given. Because of the volume of mail, we won't be able to respond to all questions personally. Questions may be edited for length and clarity. Starr writes about personal finance topics


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