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Investing In Times Of Uncertainty And Risk: The Importance Of Diversification

A lot of people have been scared out of the investment markets since September 11. Statistics that show that stocks and bonds are excellent long-term investments are cold comfort when it’s your net worth that’s tumbling. In times of uncertainty and risk, it’s hard to avoid the tendency to call a halt to investing, put your money in a mattress, and avoid the markets entirely until things look better.

If history has a lesson to teach us, however, it’s that decisions made out of fear are the ones that prove most costly over time. What is needed is not just caution, but perspective. And the best way to gain it is for investors to meet with their financial advisor to review their long-range objectives, current financial situation, and risk tolerance, and arrange for their investments to be allocated among stocks, fixed income investments, hedges, REITs and cash in a way that will help an investor reach their goals.

For most investors, the cornerstone of the conversation should be diversification, an investment principle too often neglected during the bull-market run-up of the 1990s. For many investors, the lure of sharply rising stock prices was too much to resist, and as a result, they weighted their portfolios heavily toward equities, particularly technology oriented stocks. Why, after all, settle for merely “average” returns when the stock market and technology, in particular, offered a seemingly endless opportunity to get rich fast.

The answer, as recent events have demonstrated, is the risk of losing some or most of your investment capital. The ability to limit risk while earning attractive returns is precisely where diversification comes in.

Most investors, of course, have an intuitive grasp of risk and the importance of diversifying their portfolios by time (short-term vs. long-term holdings), asset classes (for example, stocks, bonds, and money market instruments), securities (avoiding concentrated positions in any single holding), and sectors. They often don’t, however, have a clear idea of why it’s important to avoid putting all their investment eggs in one basket.

The reason has to do with the avoidance of what statisticians term “investment correlation.” In fact, the greatest risk any portfolio faces is that identical or closely related developments or economic forces will affect the investments that comprise it. For example, a portfolio may be broadly diversified across the U.S. stock market, but if a broad economic slowdown or recession hits, many of its holdings are likely to decline in price.

This avoidance of investment correlation is the reason that effective asset allocation plans almost always contain multiple components, that is, assets that usually don’t move up or down in lockstep. While the math behind effective diversification across asset classes can seem complex and abstract, the results are straightforward and practical. By combining assets that are not strongly correlated, investors expect to maintain overall portfolio returns while reducing portfolio risk. And that’s true even if the assets they add to their portfolios are more volatile in the short-term than the portfolio as whole.

This ability to reduce the risk assumed to earn a given return is the real advantage of diversification – and the reason it’s important to take the time to arrange for an investor’s portfolio to be allocated in a way that will help them reach their long range objectives.

For further information about minimizing volatility and earning higher long-term returns, call Louis P. Stanasolovich, CFP™ at (412) 635-9210, extension 18.



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