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Diversification—A Major Key to Successful Investing

If you do nothing else as part of your active management, you are likely to reduce risk considerably and probably even add to your returns by maintaining proper diversification in your investment account.

Diversification means allocating your investments in different areas so that your portfolio’s various investment segments do not tend to rise and fall at the same time but instead, as a group, move more smoothly and with less volatility than any single investment alone. Mutual funds are popular because, to some extent, all mutual funds provide some element of diversification compared to the purchase of one or two single stocks and therefore involve less risk. You will learn more about diversification as you progress through this book. For now, let’s just consider some ways in which you might diversify your portfolios.

Geographic Diversification in the Developing Global Economy

There have clearly been many changes in the balance of economies across the world. For years and years, the U.S. economy and, to a lesser extent, the economies of Europe were dominant in the world, reflected in the strength of the various stock and bond markets of the Western world. Japan eventually emerged, during the 1980s, as a major national success. The Japanese market soared into its own speculative bubble, which came to a conclusion at the end of 1989 and has not fully recovered since.

Figure 1-3 illustrates the significant shift that has taken place in the relative performance of the U.S.-based Standard & Poor’s 500 Index and a cross-section of overseas stock markets as reflected in the EAFE Index.

Figure 1.3

Figure 1-3 The Standard & Poor’s 500 Index versus the EAFE Index, 1999–2005.
The U.S. market clearly led the EAFE (Europe, Australia, Far East) Index in its performance between 1995 and 1999, rising by 231% compared to 69% for the EAFE Index during this period. The performance of these two indices became more equal during the bear market, 2000–2002, with foreign markets clearly taking the lead in performance starting in 2003.

In recent years, particularly since 2002, economic strength has expanded from the United States to countries such as China (most obvious), India, New Zealand, Mexico, Brazil, and Australia (to name just a few). Whereas manufacturing nations led the world economically in the past, nations that provide the commodities needed by those manufacturing nations have risen more recently in relative economic strength and power. As a result, the currency of New Zealand, which has a commodity-based economy, has become competitive over the years with the U.S. dollar. The New Zealand stock market, which generally lagged the American stock market in strength, has also, in recent years, become competitive with our own stock market, as have stock markets in many of the emerging nations previously mentioned.

Economic strength abroad relative to strength in the United States has been reflected in the relative strength of currencies as well as the relative strength of stock markets. The Canadian dollar, for example, has shown long-term strength superior to the long-term strength of the U.S. dollar. (We return to currency relationships when we consider investment opportunities in bonds issued by foreign countries.)

The moral of the story should be apparent enough. For decades, even though foreign stock markets did enjoy some periods in which they outperformed the U.S. stock markets, the name of the game was to buy American. This is no longer the case. The present strategy of choice is to keep track of stock markets across the world, identify the market leaders, and diversify at least a portion of your assets among the leading stock markets worldwide. You will learn how to do this and where you can readily find investment vehicles to employ.

Diversifying Geographically in Foreign Bond Markets as well as in Domestic Income Investments

In a similar vein, credit instruments issued by foreign governments often provide opportunities that are superior to domestic credit instruments. For example, at a time during 2004, when American 1-year Treasury notes were yielding approximately 2%, 1-year New Zealand Treasury notes, fully backed by the New Zealand government, were yielding in excess of 6% per year. There was virtually no credit risk involved, although there were risks associated with currency relationships. Inasmuch as investors had to convert U.S. dollars into New Zealand dollars to make the purchase, and inasmuch as the investment remained denominated in New Zealand dollars, your income would be supplemented by currency gains if the New Zealand dollar continued to rise against the American dollar or would be offset by potential currency losses if the New Zealand dollar were to decline against the American dollar.

In effect, you were virtually guaranteed an extra 4% per year in interest income, and you might or might not improve this differential as a result of currency fluctuations. Given the weakness of the U.S. dollar at the time, the investment offered a double opportunity to aggressive income investors.

Many mutual funds—open-end as well as closed-end funds (funds traded on the various stock exchanges that have a fixed number of shares and that trade between existing shareholders and new shareholders)—provide access into foreign stock markets and into foreign income instruments. You will learn more about such funds throughout this book.

In the meantime, start to think globally. The diversification should reduce risk and, in many cases, will most likely improve opportunity and return, too.

Sector Diversification for Smoother Performance and Risk Reduction

Tables 1-1 and 1-2 illustrate the benefits of diversifying investment portfolios to include a variety of market sectors whose prices do not generally rise and fall simultaneously so that losses in some areas are generally offset by advances or by lesser loss elsewhere. The total portfolio, as a result, usually performs better than its parts taken separately.

Table 1-1 Nine Investment Classes*

Performance of Each Class of Investment Taken Separately June 1980 through November 2004

Sector

Average Gain per Annum

Maximum Open Drawdown**

Financials

17.1%

–35.1%

Health Care

16.0

–39.6

Real Estate

13.1

–21.9

Utilities

11.6

–45.3

Dow Jones Transports

11.2

–45.5

Energy

 9.1

–46.7

Gold/Precious Metals

 5.0

–68.9

Lehman Aggregate Bonds

 9.5

 –9.0

Global Bond

 9.3

 –9.1

Average, All Sectors

11.3%

–35.7%

Average, Excluding Bonds

11.9%

–43.3%


* -The above table represents the average performance of universes of mutual funds that designate investments in these areas as their primary objective. The Dow Jones Transports and the Lehman Aggregate Bond Index are the exception. They reflect the performance of these price indices, including in the Lehman Bond Index, interest payouts from bond holdings, and the price movement of bonds included in the index.

** -"Maximum open drawdown" represents the largest decline in the value of investments in the above areas from a peak to a low point in value until new highs in equity value were achieved. This must be considered the minimum risk level of any investment because investors, during the period shown, did actually incur these levels of loss.

Table 1-2 -Nine Investment Classes—as in Table 1-1—Grouped into One Portfolio

Starting with an Equal Amount of Assets in Each June 1980 through November 2004*

Equal Starting Amounts, Including Bond Sectors, No Rebalancing

Average Gain per Annum for Total Portfolio

 12.6%

Maximum Open Drawdown

–22.4%

Equal Starting Amounts, Excluding Bond Sectors, No Rebalancing

Average Gain per Annum for Total Portfolio

 13.2%

Maximum Open Drawdown

–26.2%

Equal Starting Amounts, Including Bond Sectors. Equalize Sector Assets at Start of Each Year, Including Bond Sectors

Average Gain per Annum for Total Portfolio

 12.3%

Maximum Open Drawdown

–19.7%

Equal Starting Amounts, Excluding Bond Sectors. Equalize Sector Assets at Start of Each Year

Average Gain per Annum for Total Portfolio

 13.0%

Maximum Open Drawdown

–24.2%


* -In portfolios that are not rebalanced, it is presumed that assets were equally divided at the onset of the study period (1980) and from that time forward assets were neither added to nor removed from any segment of the portfolio. At the end of the study period, then, some market sectors had increased in their proportionate size; some had decreased.

-In the portfolios that were equalized at the end of each year, assets were redistributed at the start of the new year so that each sector started once again with the same-size portfolio.

We return to issues regarding diversification, including additional ideas for portfolio structure, in Chapter 2, "Putting Together a Winning Portfolio."

 

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