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Today isn't a good time to forgo diversification

January 26, 2009
Diversification, one of the most revered investment principles, has failed to protect investors during the current market storm. Securities markets around the world succumbed to the vicious bear market that wreaked havoc on portfolios during the fourth quarter of 2008.

Only a very few investment choices, such as owning U.S. treasury bonds, holding a lot of cash or selling short, would have provided investors shelter from the steep declines. Unfortunately, in most diversified portfolios, including those constructed with the help of financial planners, none of those options would typically occupy a significant slice of the portfolio pie.

Thus, it's understandable that investors are frustrated with the magnitude of the declines in their portfolios, particularly when they believed they were doing the right thing in holding a broad variety of investments. Many investors had gravitated back to diversified portfolios following the tech-stock meltdown in 2000. As that bubble burst, too many investors held portfolios chock full of the hot-performing technology stocks. That painful market decline reminded investors of the pitfalls of "having all your eggs in one basket" and had them revisiting the benefits of diversification.

The ability for investors to achieve wide-ranging diversification has become considerably easier in recent years. Choices are much more numerous than the standard old mix of stocks and bonds.

Today, investors can gain exposure to commodities through mutual funds, and real estate through real estate investment trusts and timberland REITs. Exchange-traded funds have been created that invest in specific countries, currencies and emerging markets.

Closed-end funds are available that invest in bank loans or distressed high-yield securities. There are even mutual funds that claim to invest like private-equity funds and hedge funds.

Other recent investment industry products are the so-called "lifestyle" or "target date" funds." These are generally mutual-fund portfolios that invest over a given time period based on a specific upcoming event, such as job retirement or anticipated college education costs. These funds were also not immune to 2008's bear market.

But now, investors disheartened that this investment tenet let them down are abandoning diversification in droves. They are liquidating stocks, bonds, real estate and moving to cash, such as money-market funds, treasuries, or certificates of deposit that earn next to nothing (or, as they say, depositing to the "Bank of Sealy").

Today, we regularly hear a number of "experts" argue that buy-and-hold investing is dead. They wrongly assume that stocks have become riskier after they have already dropped some 40 percent in value and instead suggest that investors should trade in and out of the market as if they were sitting in a casino.

We think that sort of talk is nonsense, and rather believe that now more than ever investors need to have a long-term view toward a positive future that will occur three to five years down the road.

We have never been strong advocates of a broad diversification strategy, instead recognizing that a handful of carefully chosen investments can outperform the averages. However, with assets selling at depressed prices across the globe, the outlook for broadly diversified portfolios looks great over the long term. Unfortunately, as is often typical, the herd is stampeding in the wrong direction.

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. Views expressed are his own. He can be reached at ken@aldebarancapital.com.

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