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Boom-Bust Cycle Shows Investors Should Diversify To Prosper

For decades, investors slept soundly in the knowledge that if they allocated their assets adequately among stocks, bonds and cash, they’d fair well enough over the long haul.

But that was before the bears took over in 2007.

The market boom and bust, from which most portfolios are still recovering, not only left investors questioning their tolerance for risk, but helped shine the spotlight on the importance of diversifying—among and within asset classes.

According to Michael Gibney, a certified financial planner for Highland Financial Advisors in Riverdale, N.J., meeting one’s financial goals today is less about picking great stocks than it is about balancing exposure and risk.

“If you want to outperform the market, you need to include asset classes that are not highly correlated with the overall market,” he says. “When you do that, you minimize risk.”

Indeed, Modern Portfolio Theory, upon which standard asset allocation models are based, maintains that volatility is minimized and performance enhanced when investors combine assets that produce varying returns in any given market.

Balancing Act Tougher Than Ever

Stocks and bonds are a good example, since the bond market tends to slide when Wall Street’s soaring—and vice versa. As such, they typically serve as the foundation for a well-balanced portfolio.

Yet, sector allocation, in which investors spread their stock and fund picks among different markets and industries, plays an equally vital role.

“You need exposure to parts of the economy that will behave in different ways at different points in time,” says Christine Benz, director of personal finance for Chicago-based fund tracker Morningstar. “Otherwise, you might end up with a portfolio that’s dangerously lopsided, one that would perform great in some markets and terrible in another.”

Most portfolios, she notes, should include a broad mix of small-, mid- and large-capitalization stocks across all major industries, including financials, telecommunication, industrials, energy, consumer goods, commercial real estate, utilities, basic materials and health care.

They should also include some exposure to international markets, both developed and emerging.

“Even within the consumer goods category, it’s important to have both cyclical stocks that are more dependent on how the economy is doing as well as the more stable consumer staples, like grocery stores, that tend to do well no matter what the economy is doing,” says Benz. “The more diversified you are the better the odds that you’ll have something performing well in your portfolio at any given period of time.”

The same is true of bonds, commodities, and other securities.

Morningstar recommends that “moderate” retirement savers in their mid-40s allocate roughly 13 percent of their portfolio towards bonds—with 10 percent in domestic fixed income (like Treasuries) and 3 percent invested in bonds issued outside the U.S.

“There’s been a lot of chatter recently about Treasurys being a terrible investment given the deficit and the fact that you are getting little yield, but they have little to no credit risk and in a week like we just had [in which the Dow dove nearly 300-points] Treasuries held their ground superbly,” says Benz, noting your U.S. bond allocation could also include corporate and asset-backed products, which march to their own drummer.

At the same time, most planners suggest the average investor allocate roughly 5 percent of one's portfolio to commodities for the inflation hedge they provide and because they do not correlate highly with stocks or bonds, but they agree it’s risky to single out any one sub-sector like energy or gold.

Commodity mutual funds that track one of the broad commodity indices provide instant diversification within the asset class and are an easy point of entry for most investors.

How Mutual Funds Fit In

Ironically, mutual funds, which are themselves a basket of stocks or bonds, present a particular challenge for investors seeking diversification.

That’s because most assume funds help lower their level of risk. They can but only if used appropriately.

“New clients often tell us that their current portfolio is highly diversified simply because they have seven mutual funds, but five of those may be large cap growth funds and their top 10 holdings include many of the same companies,” says Gibney.

It’s not enough to pick funds based on ratings and investment style alone, says Benz, especially if they’re actively managed ones.

“It pays to drill down into the funds you own rather than taking the managers at their word that they’re doing what they say they’re doing,” she says. "Value funds might have a growth stock or two mixed in.”

Benz notes investors who pay for active management [via expense fees] generally want their managers to keep their eyes open and take advantage of opportunities that present themselves in the market, even if it means veering from their stated strategy.

But that makes it hard to ensure your overall portfolio doesn’t become overweight in any given category.

One simply way to prevent overlap within your portfolio is to scan the top ten holdings in each of your funds.

You can also use online tools provided by many fund companies and financial news websites, such as CNBC.com's, which allow you to input and analyze your portfolio investments.

Morningstar’s version is the X-ray tool.

Perhaps the easiest way to take the legwork out of the equation, however, is to switch to more passively managed funds or index funds, which never veer from their stated style, says Gibney.

“Once you get out of index funds and into managed funds, that’s when you run into style drift,” he says.

Be aware, though, that index funds alone may not be enough to spread your eggs adequately among all baskets.

“The S&P 500 is heavily weighted towards large cap growth stocks so you’ll have to include small caps that are not highly correlated with the index,” says Gibney. “We even break it down between small-cap growth and small-cap value because we want them to work together to minimize risk.”

Increasingly, investors looking to meet their long-term financial goals must take the time to know what they own and be more proactive in allocating across the spectrum of asset classes.

Doing so will not only reduce the ups and downs in their portfolio, but give them the confidence to maintain their target allocation when the bears come back again—the key to preventing costly market timing mistakes.

“Time and again, the value of maintaining one’s discipline in the face of terrifying events has been proven,” says Kevin Gahagan, a certified financial planner with Mosaic Financial Partners in San Francisco. “When one owns markets rather than individual stocks, it is easier to believe in recovery. In this same vein, when one’s portfolio is diversified across a range of markets, the prospect of future recovery is better.”