Diversity is key to success of portfolio over long run


March 17, 2002|By Eileen Ambrose

Diversification doesn't guarantee the highest returns, but it does smooth out the volatility in a portfolio so investors are more likely to stick with an investment plan long enough for the plan to work.

"If your portfolio is down 20 percent one year and up 40 percent next year, you're much more apt to make mistakes than if your portfolio simply goes up 12 percent every year," said James K. Glassman, author of The Secret Code of the Superior Investor.

Basically, a well-diversified equity portfolio includes domestic and foreign; growth and value; and large-, small- and mid-cap stocks.

That may sound simple enough, but even investors holding a variety of stocks can unwittingly end up less diversified than desired.

For example, someone may own 20 stocks, but all of them in technology, so the portfolio will rise and fall with a single sector. Or, an investor may own a dozen or so mutual funds that hold many of the same stocks.

How do you achieve a diversified stock portfolio?

Investors first need to consider their asset allocation, or how much money they want to hold in stocks, bonds and cash. The right allocation depends on investors' goals, years to invest, and how much risk they can handle.

You also must decide what you expect from the stock portfolio, experts said. Older investors who want income, for instance, may lean toward shares in mature companies that pay good dividends.

While individual factors will shape a stock portfolio, here are some diversification techniques:

Keep it simple. If you don't want to keep an eye on more than a dozen individual stocks or wade through multiple fund prospectuses, consider buying one or more index funds, experts said. These funds mimic an index, such as the S&P 500 Index or Wilshire 5000 Index. With one of the broad market index funds, you never will do better than the market, but you won't do much worse.

Or, consider a fund of funds, which reduces the chore of having to choose among thousands of funds, said Peter Di Teresa, senior analyst with Morningstar Inc., a Chicago financial research firm. This type of fund invests in about a dozen other funds. A fund of funds may be designed to fit investors' risk tolerance or length of time to invest, he said.

Mutual funds. A 1998 Morningstar study found that investors can get all the diversification they need from four funds - "if you buy the right four funds," Di Teresa said.

He suggests a bond fund, a total stock market index fund and an international fund. Investors can use the fourth fund to tweak their portfolio to their liking, such as adding a conservative value fund or more aggressive small-cap fund, Di Teresa said.

The Morningstar study also found that after seven to 10 funds, the benefits of diversification didn't increase. The portfolio didn't become less volatile and investors often owned some of the same stocks in different funds.

Overlap. To avoid owning funds that hold the same stocks, check the funds' entire portfolios, which are released twice a year. Some fund companies release updates on their top 10 holdings every month, Di Teresa said.

T. Rowe Price Associates in Baltimore makes the job even easier. It offers for free Morningstar's Portfolio X-Ray (at www.troweprice. com), which allows investors to plug in their mutual funds, individual stocks, cash and bonds. The program then breaks down how heavily weighted the portfolio is according to sector and region of the world, and tells you what percentage of your portfolio is made up of an individual stock.

Individual stocks. For years, investors have been told they could achieve adequate diversification with 15 to 20 stocks in different sectors. But a 2000 study concluded that because individual stocks had become so much more volatile, investors needed to own as many as 50 stocks, Glassman said, "which is completely ridiculous. Impractical."

Instead, Glassman suggests buying 15 stocks, or 20 at most, and using mutual funds to make up any diversification shortfall. The 15 or 20 stocks should be divided among about a half-dozen sectors, such as energy, retail, finance, technology, manufacturing and consumer products, he said.

He also advises owning income-producing investments, such as a real estate investment trust that distributes most of its taxable income to shareholders through dividends.

To gauge whether you may be over-investing in one sector, experts suggest using a benchmark, such as the S&P 500 index. For example, utilities make up about 3 percent of the index and technology amounts to around 20 percent.

"You don't need to match it precisely," Di Teresa said. But, "if I put 35 percent of my portfolio in technology, that's a sign to me that I have an unusually big stake there," he said. He also advises that one stock should not make up more than 10 percent of an investor's entire portfolio of stocks, bonds and cash.

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