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June 1, 2009

Does Diversification Still Work?

ATT002612008 was a miserable year for investors.  The recession which began in 2007, was magnified by the sudden collapse of Lehman Brothers.  The shock of that event sent the economy into a tailspin.  Fear and panic ensued.  Credit was nowhere to be found.  The price of commodities like oil, gas, copper and tin plummeted.  Stock markets around the world crashed.  Every sector experienced a fall.  Investors fearing the worst moved to U.S. Government Securities for safety, making them the only securities that went up in 2008. To make a bad situation worse, the Bernie Madoff scandal broke.  Billions and billions of investors’ dollars were stolen in a Ponzi scheme that lasted for years.  Investors understandably felt shell shock.  Panic, confusion and anxiety ruled the day.

Pundits, (more often than not, the voice of doom), decried diversification as a failed investment strategy.  The reports of the diversification demise was written in the newspapers, on the web, and voiced on the radio and television.  But was it true?  Does diversification still work?  Does it reduce risk?  If so, what is the best way to diversify?

Now that some time has passed and the dust is settling, we can stand back and take a long look at what happened last year.  The credit freeze of 2008 is what is referred to as a “black swan” event.  In the 18th century, scientists believed that all swans were white.  In point of fact, all swans observed up to that date were white.  Then, low and behold, they discovered black swans in Australia.  Since that time, “black swans” have come to
represent things which were unforeseeable in the future, but appear perfectly reasonable from hindsight.

The 2008 credit freeze and its repercussions were such an event.  The legions of economists’ Wall Street bankers, banking regulators, politicians, journalists, and investors did not see this coming.  For sure, there were those of us who saw the housing bubble, and some of the problems that might hurt the banking sector, but few, if any, foresaw the degree of the credit freeze and the subsequent meltdown that occurred in the capital markets.

With that said, did diversification help?  Let’s look at some facts. According to Don Phillips, Managing Director of Morningstar, 2,886 out of 10,691 U.S. stocks lost more than 75% in 2008.  Only 1 out of 15,272 non-leveraged U.S. stock funds lost more than 75% in the same period. Diversification did, indeed, work.  If you were a stock picker, you had 1 out of 4 chances of losing more than 75%.  Compare that to 1 out of 15,000
for someone with a diversified fund.

Allow me to reiterate, 2008 was a terrible year for nearly all investments. Even diversified funds were down significantly, but diversification did lower risk.  In the worst market conditions in over 70 years, diversification paid off.  How can you go about diversifying your portfolio?

There are three main ways to diversify your stock portfolio.  First, you can buy individual securities.  This requires a great deal of time and money. For example, to achieve diversification in the S&P 500 index, you need to own shares in 100 different companies, and then you are diversified within just one asset class.  You need more funds to diversify among different asset classes (mid cap stocks, small cap, international, etc).  Frankly, this option is not right for most folks.

A second option is hedge funds.  These are private investment pools for “accredited” investors.  Since “accredited” investors must have a high income or net worth, the hedge fund managers are not required to follow the strict rules, regulations and laws that other funds must follow.  Hedge funds can invest in virtually any investment, including derivatives.  The fees hedge funds charge investors start at 2% and can go up to 30% based on performance.  Thus, a hedge fund manager has a strong incentive to take risk.  Hedge funds have literally become the “wild west of investments”. Bernie Madoff ran a hedge fund.  The lax rules and regulations made it easier for him to commit his Ponzi scheme.  Only very sophisticated investors should consider hedge funds.

A third option includes mutual funds, ETFs, and variable annuities.  These offer a cost-efficient way to diversify within and between asset classes. In addition, they fall under the strictest regulations and supervision. Reporting rules and requirements make these investments transparent.  Each fund must specify how their assets are managed, what type of investments they purchase, and what investment objectives they are attempting to

It must be remembered that even well-managed investments go down in a bear market.   But, bear markets give us the opportunity to review how well each fund manager managed risk through the hard times.  Comparing and contrasting investment options is a difficult proposition.  We must compare apples to apples.  Every investment fund has its own objective; therefore, we must compare like funds to like funds.  Second, we must marry up our investment needs, goals, and desires to the appropriate fund, or more likely, a compilation of funds.  Third, we must keep our eye on each fund.  If performance slips (in their respective category), then we must consider making a change.  Ongoing review is a must.

Money Concepts is here to help.  We have the tools, knowledge and experience to help you make an informed, thoughtful decision for you and your family. We will carefully review with you your investment objectives, goals and risk tolerance.  We will provide you with a full disclosure of all fees, cost structures and risk characteristics of any investment prior to any investment decision.  We are truly independent advisors.  We do not offer any proprietary products whatsoever.  We are not owned or controlled by any
investment management firm, insurance company or other financial institution.  Our goal is to work with our clients to achieve their objectives, reduce their frustration and anxiety.

Please feel free to pass this on to anyone you feel might benefit.  We appreciate all of your referrals.