Are you Diversified?

If you have ever watch Jim Cramer and his segment “Are you diversified?” then you probably have some idea what lack of diversification means. The problem is that many investors think they are diversified and therefore protected from the market’s risks (at least somewhat). Well, this might not be accurate.

Gary Marks a successful money manager has written a book that is causing some problems with some brokerage firms. The book Rocking Wall Street: Four Powerful Strategies That will Shake Up the Way You Invest, Build Your Wealth And Give You Your Life Back received a highly complimentary statement from a senior portfolio manager at a major brokerage firm that lead the firm’s compliance department to issue a written warning to Mr. Marks not to use his quote to promote the book.

This book offers ideas to help develop a philosophy of investing; explaining specific strategies and techniques to create your own diversified portfolios that balance the risks and rewards of the market. For example, what if the current diversification models were considered too risky and ineffective?

When hedging your investments one of the most common assumptions made, yet not usually mentioned, is all the investments are based on the upward trends in the markets or stocks. When this happens your diversification actually decreases. The reason is that all you assets are counting on the up trends and/or well being of the global markets.

When bear markets happen, they usually make the assumption they will have the staying power to wait out the losses they experience during a bear market. But what if the bear market lasts years, or maybe even a decade? During the twentieth century the average secular bear market in the U.S. was 17 years. During that time investors can lose fortunes for themselves and their families. Not many of us have the financial or psychological strength to sustain ourselves during these down cycles.

Most investors remember the downturn that started in 2000 and went through 2002. Their 401(k) accounts, IRAs and personal portfolios lost 20 to 50 percent of assets value. Remember if you lose 50% of the value of a portfolio, then the portfolio must now double (grow 100%) just to get back to where you were. That can is hard to accomplish and takes time.

These investors felt they were diversified having spread their portfolio among stocks from different sectors as well as holding bonds and some cash. Yet they still experienced significant losses. The list below provides a sampling of what happened too many of the indexes and asset classes traditionally used to diversify portfolios from their historic highs in 1999 or 2000 to the end of 2002.

Ok, what if an investor had the broadly diversified 60/40 stock to bond portfolio during this down turn? For the 60% stock portfolio let’s assume this investor held the S&P 500. For the 40% bonds lets use the Lehman Aggregate Bond Index from 2000-2002. Holding these two indexes would have produced a 16% loss during this time frame. Not a very good return for a conservative portfolio that is properly diversified. Just imagine the loss if this investor had been more diversified in NASDAQ and foreign stock indexes.

This analysis is telling us that traditional ways of diversification won’t save you. Essentially true diversification must include more investment choices than just stocks and bonds. It includes investments that offer alternative ways to generate positive returns while reducing risk, such as home ownership, savings plans, etc.

Just to remind everyone, the one day fall on February 27, 2007 that has received so much press due to China’s 9% market decline generated the following losses in the indexes:

Once again diversification may have not provided the lower risk strategy as expected. I will have more on this topic throughout this year.