Ask Lynn - This Week’s Column

Is there anybody out there who’d rather not be sitting on top of the world? When you let your mind wander, perhaps you live in a house so large you get lost trying to find the laundry room. You don’t need no stinking Atkins diet because you’ve got the flattest abs on the beach and your kids are smarter than their teachers. In this fantasy world, even your dog or cat is better behaved than the trained pooches on TV commercials.

But with investing, being No. 1 isn’t what it’s all about. The wisest investors aren’t shooting for the most spectacular returns. Instead, they diversify their portfolios to maximize their returns and protect themselves from a potential financial tsunami.

Asset allocation, as you may have figured out from last week’s column, isn’t about hitting home runs. As an investor, what should keep you from swinging for the upper deck of the Western Metals Building is fear. You can’t chase the highest returns unless you are willing to lose your sleep and possibly a big chunk of your 401(k), Individual Retirement Account and the kids’ college money. When you diversify across different types of assets, you are more likely to hit single and doubles, but your investment risk is much lower.

In contrast, when you aim for the biggest, showiest returns, you essentially drench your portfolio in lighter fluid. With an undiversified portfolio, you may bet on a narrow market niche. Remember, when people threw all their money at dot coms? The profits were stupendous until they incinerated.

If you’d love to have a diversified portfolio, here are some steps to follow:

Examine your latest investment account statements. Do you know why you’ve been holding onto this stuff? Would you buy the same investments if you could strap your portfolio into a time machine and jettison back 10 or 20 years? Probably not.

Just because you own lots of investments doesn’t mean that you’re practicing asset allocation. A stock jockey might think he’s safely diversified because he owns Microsoft, Pfizer and two dozen other blue chip stocks. This type of portfolio is horribly risky because all the cash is sunk into just one asset class, large-cap growth stocks.

Identify your portfolio’s asset classes. Not sure what they are? Here are the major equity categories: large-cap stocks, small-cap stocks and foreign stocks. It’s not as simple to describe the big fixed-income groups. One way to classify bonds is by their maturities. There’s short, intermediate and long-term bonds. (It’s generally best to avoid long-term bonds, because investors aren’t rewarded for the extra volatility.) Bonds are also grouped according to the borrower. There’s federal Treasuries, state and local municipals bonds, corporate bonds and overseas bonds.

Learn more about asset-class returns. Many aggressive investors, who don’t blanche when the market drops like a manhole cover, bulk up on growth stocks. If they knew their history, they’d probably spend more time shopping in the dog pound. Historically, beaten-down value stocks have performed better than growth. And small companies have performed better than large ones. According to Ibbotson Associates, if someone had invested $1,000 in small-cap value stocks in 1927, the cash would have mushroomed to $38 million recently. If that same cash was sunk into large-cap growth stocks, the ending balance would have reached a mere $1 million. Does this mean you should ditch growth and embrace value? Absolutely not. You want a mix, but how much growth versus value will depend upon your own circumstances, including your stomach for risk and your time horizon. Aggressive investors, who know what they are doing, tend to weight their portfolios more heavily towards small-cap value and foreign-stock funds.

Check your portfolio’s volatility. One common way to determine if an investment has a short fuse is to know its standard deviation. Standard deviation is one popular measurement of risk. The greater the standard deviation, the higher the investment’s risk. You can find the standard deviation of any mutual fund that Morningstar tracks by clicking on “risk measures.” If you have a financial advisor, he or she should be able to tell you the standard deviation of each of your stock and bond holdings. If the advisor can’t, that’s a problem.

Get help. Understandably, many people have a better chance of hitting the high notes during the National Anthem than assembling a model portfolio. A good financial planner can help.

But what about the do-it-yourselfers? Here’s a short cut: Visit the web site of IndexFunds.com. Once there, you can find 20 model portfolios that you can look at to get ideas. You’ll see historic returns and standard deviations for each portfolio. The most timid portfolio invests 85% of its cash in short-to-intermediate government and global bonds. The riskiest portfolio is heavily weighted towards small and small-cap value funds (40%) and foreign equity funds (31%) with no fixed-income exposure.

Start reading. You won’t learn the backstroke by watching the swimmers at the Summer Olympics and you sure can’t become a diversification whiz by reading this column. If you’re serious about a portfolio spring cleaning, you’ve got to hit the books. Pick up a copy of The Intelligent Asset Allocator, by William Bernstein and if you slog through that, try his companion title, The Four Pillars of Investing. You might find The Smartest Investment Book You’ll Ever Read by Daniel R. Solin and The Only Guide to a Winning Investment Strategy You’ll Ever Need, tad lighter reads.

Start diversifying. The perfect portfolio for you may not look anything like the best portfolio for your mother-in-law or the cable guy. If you prefer a super-simple solution, here’s a possible bare-bones asset mix: large-cap stock mutual fund, small-cap stock fund, foreign stock fund and short-term bond fund. If you want to get fancier, divide these asset classes into growth and value. You could invest, for example, in a small-cap value and small-cap growth fund. Of course, the simplest and best way to invest in any asset classes is through index funds.

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This entry was posted on Saturday, July 7th, 2007 at 8:33 pm and is filed under Investing Behavior. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.