Investor Psychology

Cut Your Risk

It's not foolproof, but diversification is still a smart strategy.

It wasn't hard to feel like a chump in 2008, when stocks, corporate bonds and commodities all tanked at the same time. The experts said we would be protected from disaster by spreading our risk among those different kinds of investments. But we weren't.

Does that mean a strategy of holding a diversified portfolio is dead? Hardly. "It's kind of unfair to point the finger at asset allocation," says Jerry Miccolis, a New Jersey investment adviser and coauthor of Asset Allocation for Dummies. "The only people who didn't get hurt were those who weren't invested." But putting your money under the mattress is no long-term strategy. If inflation runs 3% annually, in just 14 years you'll need $1.50 to buy what costs $1 today.

The long-term performance of stocks -- an annualized return of 9.7% since 1926 -- is a powerful argument for keeping most of your retirement assets invested in them. Yes, they are volatile. But in all but the most extreme circumstances (like those we saw in 2008), holding bonds and other assets can minimize the damage.

That may sound like the same old investment advice handed out before the crash -- and it is. But that doesn't mean you can't improve on it. Here are some tips for getting the most out of your asset allocation. This advice applies to a portfolio intended to grow over ten years or longer and not to any cash you may keep on hand for short-term uses.

Stick with stocks. Even though Standard & Poor's 500-stock index lost 55% between October 2007 and March 2009, stocks should still account for close to half of your portfolio -- even if you're close to retirement. There's a better-than-even chance that at least one of a pair of spouses retiring today at age 65 will still be around at age 90, says Ned Notzon, of T. Rowe Price. Inflation can ravage a bond-heavy portfolio over that time. That's why Notzon thinks new retirees should have at least 40% of their assets -- and preferably 55% to 60% -- in stocks.

Don't forget the rest of the world. Non-U.S. companies account for more than half the value of the world's stocks. They should be represented in all but the most conservative portfolios. Keep in mind, though, that many large companies in the U.S. and elsewhere operate globally. That means that foreign stocks aren't as different from U.S. stocks as they used to be and don't provide as much diversification benefit as they once did. Stocks from developing nations, such as China and India, provide better diversification.

Look beyond bonds. We like the idea of looking beyond stocks and bonds, but caution is in order. Alternatives should be simple and have a successful track record. Among those we like: real estate investment trusts, funds that track commodity prices and certain low-risk funds that adopt hedge fund-like strategies. Something altogether different and appropriate for even conservative investors is a fund like Merger (symbol MERFX), which buys shares of firms that are being acquired. During the 2008 disaster, it lost only 2%.

Rebalance. Restore your portfolio's original allocation by selling assets that have performed relatively well and buying those that have performed relatively poorly. Rebalancing is a contrarian strategy. "It forces you to sell high and buy low over and over again," says Miccolis. You should rebalance at least once a year. Miccolis recommends doing it whenever your allocation shifts by a couple of percentage points. But weigh the benefits of rebalancing against the cost of commissions and taxes.

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