From the July 2007 issue of Boomer Market Advisor • Subscribe!

Don't misunderstand boomer diversification

Simply diversifying assets among different mutual funds does not insulate investors against market downturns. Contrary to belief, owning a number of different funds does not reduce risk in a portfolio. It makes as much sense as burying cash in coffee cans.

I'm not against asset diversification. In fact, I believe it's a good strategy to own a wide variety of mutual funds. But I question conventional wisdom about diversifying risk. It's not about the number of funds, sectors or categories the client owns.

Too many investors believe they're safe if they spread money around, even if it's in the same style of fund in different fund families. It's not that average investors aren't knowledgeable or diligent in their fund choice. More likely, they understand the risk associated with all their eggs in one basket but fail to understand how different these baskets need to be.

As an example, look back to January 1, 2002 (the start of the worst year in recent market history). How would the risk diversification process work for hypothetical investors with $150,000 of retirement assets?

Research and proper due diligence was conducted and 15 funds were selected. The 15 funds produced solid returns for the prior 15-year period. To diversify, they chose nine domestic equity funds from each of the nine major categories, including small-, mid- and large-cap funds in the growth, value and blend areas. They included one fund each from the technology, utilities, financial and health care sectors. One international fund and one bond fund was added for good measure.

They invested $10,000 in each fund.

Our investors had good reason to be optimistic. From 1987 through 2001, all but one of the 14 equity funds had averaged over 10 percent return when compounded annually. The returns ranged from a high of 18.03 percent to a low of 9.15 percent. The bond fund returned a measly 4.77 percent.

So how did the investments perform during the period in question? At the end of the first year (December 2002), the only positive return came from the bond fund, which produced 3.31 percent. The 14 equity funds from each of the nine categories, four sectors and international market lost between 6.34 percent and 39.78 percent. Four of the funds lost more than 30 percent and five lost more than 20 percent. The average loss for all 15 funds was 20.40 percent, and the $150,000 investment was worth $119,397.07. Keep in mind these were all top funds with solid 15-year returns.

This example illustrates what I believe to be a very simple truth about mutual funds and diversification. When the market goes up, equity funds go up. When the market goes down, equity funds go down -- period.

An obvious argument against what I've described is the fact I chose one of the worst bear markets in history. What are the chances it will happen again? I don't pretend to have the answer, but there have been other, more dramatic periods when diversified mutual fund investors have had larger losses. In fact, over the past 60 years, we've experienced 18 negative markets, an average of one nearly every three years.

So should the investors have put all their assets in just one fund and risked picking the one that dropped 39.78 percent in 2002? The obvious answer is no.

Investors not only need to look at the long-term return of a fund, but also the annual return during a specific period. They also need to take a close look the manager's approach to risk. This means a close review of the prospectus, shareholder reports, fact sheets and other relevant material.

They then must correctly diversify a portfolio by realizing it's not about the number of funds, it's about the types that are owned, the overall and relative position of the market when purchased, and the relative price of the fund.

My suggestion is to be heavily weighted in cash or bonds at peak times of market volatility, such as 2002. The opportunity cost to investors is that they miss some of upside participation, but they are protected against significant loss.

Each investor should know his own risk tolerance and investment objective. Selecting the proper investments is only the first step in diversification. Over time, an actively-managed approach with regular asset allocation decisions will help protect against market volatility. Investors who buy different funds and fail to regularly reevaluate their asset allocation will enjoy the ride up, but not the ride down.

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