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When Investment Diversification Fails

As seen on Forbes.com

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People often think investment diversification performs magic - invoke it, and it will prevent portfolio losses. Unfortunately, diversification has more limits than you realize. Even worse, since diversification typically comes at a cost, you can easily waste money by using it when it does not work.

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When bond diversification is a waste

Bonds prices are typically less volatile than equities, so they can protect portfolios against major equity declines. But bonds also provide a lower investment return. If investors don't need the price stability bonds provide, they can be a waste of money. So how can you tell whether or not investing in bonds will be useful?

You need to know that bond diversification is not the only way to avoid losses on equity investments during market downturns. Longer equity holding periods, for example, allow you to balance major market declines against subsequent gains. As long as you remain invested, time itself smooths out market losses and also allows you to earn more with equities.

A precise definition of long term depends upon how you manage your money. Arguably, however, little if any of the money that will be invested for twenty years or longer should be invested in bonds.

When bond diversification is a must

For money that will be needed in the next five years, bond diversification can be essential. Equity losses during most bear markets have averaged roughly 30%, while severe crashes can lose 50% to 60% of equity value. You do not want to be forced to sell equities after prices have plunged, so bonds are a prudent way to invest money needed over the short term.

People often think investment diversification performs magic - invoke it, and it will prevent portfolio losses. Unfortunately, diversification has more limits than you realize. Even worse, since diversification typically comes at a cost, you can easily waste money by using it when it does not work. Knowing when you will need to cash out is the key to smart bond investing. You should hedge short-term market risks with bond holdings, but using bonds to stabilize your portfolio for the long term makes little sense. You must be prepared to watch your long-term equities fluctuate in value over the short term. But as long as you do not sell out, your equities should appreciate over time.

The safest assets aren't always the safest investments

Most people know that you can lower risk (i.e., volatility) by adding bonds to an equity portfolio. By logical extension, people also believe a portfolio comprised entirely of bonds is the safest possible investment mix. It isn't.

You can improve both the risk and the return of an all-bond portfolio by adding some equity exposure. Because equity prices often rise when bond prices fall, the equities held in bond-dominated portfolios help offset bond price drops. Laddered maturities of individual bonds can also help avoid bond losses, but most investors do not have enough invested to diversify properly with individual bonds. If you invest exclusively in bond funds, equity investments are even more critical.

In the same way, other risky assets can also reduce risk in "safe-asset" portfolios. For example, large-cap U.S. stocks react differently to economic and market conditions than smaller domestic stocks. While large U.S. stocks are generally less risky than smaller U.S. stocks, portfolios should fluctuate less over time if you add some small U.S. stock exposure to large-cap portfolios.

Likewise, adding international holdings, even those from the riskier emerging markets, to portfolios devoted exclusively to domestic stocks should reduce portfolio volatility. Any time the prices of two assets are not totally in sync with each other, you can reduce the risk of portfolio volatility through diversification.

Diversification is not insurance

Insurance compensates for losses over time for as long as it is in effect. Diversification stabilizes portfolio values only when the prices of two assets diverge significantly. If asset prices that normally move in different directions move in sync when you need portfolio protection, diversification will fail you.

Bonds provide excellent diversification against equity bear markets because bonds usually rise in price when equity investors panic. During market panics, however, riskier small and international stock prices typically fall as much or more than safer large-cap domestic stocks. Risky equities can help diversify other parts of economic and market cycles, but you should not expect them to stabilize your portfolio when investors panic.

Diversification is more complicated than most people think, and often investors expect it to do more than it can. To diversify effectively, you need to understand how asset prices move relative to each other under varying conditions and how that can help you meet your investment needs and goals. Diversification can be a powerful investment tool, but you should not expect it to work magic.

About Bruce McCain

Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor's Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com. Bruce joined a predecessor of Key in 1987, after spending six years on the business faculty of the University of Iowa's Henry B. Tippie College of Business. Bruce earned a PhD in Business Administration from the University of California at Berkeley, and undergraduate degrees in Psychology and Accounting from Boise State University.

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