Why diversification will work again

By Paul J. Lim, senior editor

(Money Magazine) -- Diversification, the notion of spreading your investments among different baskets of assets that don't rise and fall in unison, has long been considered one of the safest and surest moves you can make with your portfolio. After all, if any one basket falls apart, most of your brood should remain intact.

Then along comes a market tornado like the one of 2008-09 that scrambles all your eggs, leaving you wondering what to do. Now famed hedge fund manager Jim Rogers, among others, warns, "You can go broke diversifying." TV talking heads are questioning the value of spreading your bets. And Googling the phrase "diversification is dead" returns half a million hits.

But using the financial crisis to conclude that diversification is pointless because stocks, bonds, and other assets will move in tandem forevermore is a misreading of recent history.

A better interpretation: Michele Gambera, chief economist for investment consultant Ibbotson Associates, says that market behavior in the past couple of years was attributable to the "yelling fire in a movie theater" effect. Just as the theater audience would rise in unison and race for the exits, investors move in sync away from risk and toward safety in a financial meltdown, as they did in 2008. Once the all-clear is sounded, Gambera says, they march back into the market together, bidding up all kinds of assets.

It's only when economic conditions start to return to normal -- after the movie's over, in effect -- that investors, and investments, move independently again.

That's when diversification reasserts its case, and that's where the markets are today. This snap back can take place quickly, as it did following the recessions of 1980 and 1981 and the Asian currency crisis in 1997. So what should you do now?

First, pay attention to where you're investing.

In 2008 and 2009 that didn't matter. Now that regions are recovering at different paces -- Europe's economy, for example, is expected to grow 1% this year, America's more than 2%, and China's nearly 10% -- stock and bond markets are likely to behave unpredictably. So make sure you're invested in the entire world, not just in the U.S. for safety's sake or in red-hot emerging markets in pursuit of a big score.

Second, pay attention to prices.

In 2008, says Ben Inker, head of asset allocation for investment manager GMO, assets went down across the board "because they were over-priced. Last year they were under-priced, so they deserved to go up."

Today, following that powerful rally, the situation isn't so clear.

That's why it will be important to focus on attractively priced areas, says Brian Belski, chief investment strategist for Oppenheimer. They include beaten-down blue chips in the health-care and industrial sectors, which underperformed the S&P 500 in 2009 but are leading it this year.

There's another reason to focus on so-called value shares. Since 1975, value stocks in the S&P 500 have outperformed shares of fast-growing companies by an average of seven percentage points in the second year of a rally, as the euphoria of a new bull market fades.

"Two things will make a comeback this year," concludes James Paulsen, chief investment strategist for Wells Capital Management. "The need to discriminate among assets -- and diversification."


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