Keep your investment eggs in diverse baskets

Your Funds

April 15, 2001|By CHARLES JAFFE

IT WOULD be easy to look at the first three months of 2001 and conclude that "diversification doesn't work." There were no havens in the stock market during the year's first quarter. Of the 42 categories of equity fund tracked by Lipper Inc., all but one lost money. The one winner, small-cap value, saw the average fund gain a measly 1 percent.

About 92 percent of all stock funds were losers during the three months that ended March 31, which is precisely why some investors gave up on equity funds and threw as much as possible into bond and money-market funds.

Who needs diversification, after all, when it's not going to stop the bleeding? The answer to that question is simple: You do.

The market's broad decline is not an indictment of diversification.

If anything, it proves that spreading your money around makes sense.

"Diversification is no guarantee that you won't lose money, and people tend to forget that," says Russ Kinnel, director of fund analysis at Morningstar Inc. "Diversification is supposed to save you from a death blow, a huge setback that could take 10 or 15 years to overcome, that knocks you off your goals and makes you work longer or retire poorer."

Ironically, it was little more than a year ago that investors eschewed diversification for reasons that are the mirror-opposite of why they dislike it today. Back then, the idea was that diversification was stupid at a time when an all-technology portfolio could generate huge gains. Many investors not only bought concentrated funds, which invest in just a few stocks or industries, but also held only funds that were focused on the hot points in the market.

Then the market tanked, and the very investments that might have mitigated losses - bonds or Old Economy stocks - were the things that had been excluded by a nondiversified strategy.

Many investors who shunned diversification in 1999, not wanting to give away the potential for maximum returns, are now heading for the exits. Still wanting to maximize returns, they're turning to bonds and money-market funds, the only sectors looking consistently positive right now.

"Early in a correction, people say, `I'm a long-term investor and I can stand it,' " says Don Cassidy, senior research analyst at Lipper. "Late in the move, they say, `I can't take it any more. Just get me out' or `This strategy is not working, so I'll change into things that are making money right now.' About the time people justify to themselves the need to make those moves, the market turns again." That being the case, the current conditions make the case for diversification in a particularly compelling fashion.

An investor who was fully invested in the average science-and-technology fund was up 135 percent in 1999, according to Lipper, down 33 percent in 2000 and down another 34 percent during the first quarter of 2001.

That means that a $10,000 investment made at the start of 1999 is now worth roughly $10,235.

By comparison, consider an investor who split money evenly between tech funds, large-cap core and small-cap core funds (a "core" fund being one that holds both growth and value investments). The average large-cap core fund was up roughly 21 percent in 1999, down 7.5 percent last year, and off 13 percent through the first quarter, while Lipper shows the average small-cap core fund with a 20 percent gain in 1999, a 9 percent gain last year, and a 5.5 percent loss this year.

A $10,000 investment split between the three asset classes at the start of 1999 is now worth about $10,750. That's hardly a phenomenal gain over two years, but it's better than a loss, or the all-tech alternative.

What's more, the diversified portfolio is better positioned to weather whatever the market dishes up next (small-cap value was the only equity category to actually be on the plus side during the first quarter).

What investors forget when shunning the idea of spreading money around in all market conditions is that what you are trying to diversify is risk. Owning assets in several categories balances market risk, purchasing power risk and all of the other risks inherent in an investment strategy.

Taking on a little of each of these risks blunts the spikes in performance for your holdings, up and down.

"People who think diversification doesn't work tend to put their money in the wrong place at the wrong time," Kinnel says. "The people who piled into growth, and only growth, a few years ago are now wishing they had bought some value and some things that were out-of-favor, just because it would have protected them from the huge swing the market took.

"People who completely abandon stocks now because they don't see a profitable area for one quarter will undoubtedly have regrets going forward, too."

Chuck Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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