SAN FRANCISCO – Feeling whipsawed by this market? It's times like these when a diversified portfolio is supposed to pay off. But with so many exotic choices out there, it's hard to know what diversification really means.
These days, what happens on Wall Street doesn't stay there. Gyrating U.S. stocks affect Europe, Asia and elsewhere, as has been painfully evident over the past week to investors seeking shelter from the markets' torrential storms.
So why diversify? Two words: Risk control.
Diversification keeps several pots simmering at once. It's a curious fact of investing that adding riskier assets to a portfolio actually makes it safer. The key is how much of each ingredient you use. Ultimately that depends on your taste, but if Julia Child had been an investment adviser, she would have told you that a little spice goes a long way. Putting 5 percent of a portfolio in emerging-market stocks and 5 percent in real estate, for example, has been shown to boost returns and lower volatility.
It turns out that when viewed over many years, markets aren't so intertwined after all. Stocks in the U.S. and other developed countries take independent paths, and emerging economies are in another orbit. Stocks have even looser ties to bonds, real estate, commodities and other alternative investments.
"You've got to run an efficient, diversified portfolio," said Jeremy Grantham, who oversees the investment strategies of institutional money manager GMO LLC in Boston. "You simply get a better balance of risk and return if you spread your money around."
Your options, however, seem endless. Some tap vital markets; others are just clever marketing. Confused? Here's what you need for true diversification, what's nice to have, and what you can do without.
Need to have
Stocks: Fundamentals apply. Own shares of large and small companies — only now when you buy locally, think globally. The big companies in the Standard & Poor's 500 Index, for example, generate around half of their sales outside of the U.S.
With a conservative allocation of 60 percent stocks, for example, give brand-name S&P 500 stocks 35 percent of the portfolio and send 5 percent to small-caps. Then earmark 15 percent to an international index fund that holds companies of all sizes, plus another 5 percent in a geographically dispersed emerging-markets fund.
"If the U.S. market and the global markets hang in, emerging markets will beat them," Grantham said. "They're overpriced and risky, but they're the best of the risky bets."
Bonds: The subprime mortgage mess is tainting bonds. Avoid trouble by sticking with U.S. government bonds and other top-quality issues. Bonds provide regular income, so they're a terrific diversifier, and over time show decent returns. Long-term Treasuries, for example, have delivered three-quarters of the S&P 500's 11.7 percent annualized gain since 1989 with about 60 percent of stocks' volatility, according to researcher Ibbotson Associates.
Bonds prices fall when interest-rates rise, and vice versa. Longer-dated bonds are susceptible to rate changes while short-term issues are insulated. Cover yourself with a "laddered" strategy of one-, three-, five- and 10-year debt. Consider Treasury Inflation Protected Securities, or TIPS, which unlike most bonds will hold their value as the cost of living climbs. And with mutual funds, cheaper is better.
"Have the core of your portfolio in stock index funds and bond index funds," said Jack Bogle, founder of mutual-fund giant Vanguard Group. "That's the way you will capture the largest percentage of returns that a business earns."
Nice to have
Real estate: Homeownership is probably enough real estate for most of us. But real estate does act differently from other investments. A 5 percent stake in a mutual fund or ETF that owns property stocks or real-estate investment trusts, known as REITs, should do the job. Again, think globally — the world is getting wealthier, and as the saying goes, they're not making any more land.
Don't really need
Sector funds: Buying surging technology stocks is tempting, but sector bets can turn against you quickly. "Be involved in profitable businesses around the world regardless of what's hot and what's not," said Kacy Gott, a financial adviser in San Francisco. "Don't chase sectors. That's not for investors; that's for traders."
Gold: The yellow metal insures against financial catastrophe and marches to its own drum. But as an investment, short-term risk is high and long-term reward is marginal. If you want gold, buy jewelry.
Commodities: This is a controversial call, for good reason. The price of stuff — what investment pros call "hard" or "real" assets — is soaring. China, India and other fast-growing countries need oil, natural gas, metals and materials to fuel development. With more people living in cities and making money, demand for agricultural products is also high.
You can play this trend with funds or ETFs that own a basket of commodities, and yes, you'll get diversification. But in truth, you'll do fine without direct exposure.
"Commodities are way overhyped as an asset class," said Jeremy Siegel, a Wharton School finance professor. Instead, he'd buy stock in oil producers, mining companies and other businesses that stand to profit from this global boom.
Copyright (c) 2007 MarketWatch, Inc.