Markets Pound Need for Portfolio Diversification Into Investors' Heads

The May 6 market plunge drop dealt investors a staggering blow, driving home the notion of diversification for portfolio protection. But why and how investors should be diversified is a lesson that has escaped a number of them. Are you one?

"If something happens like [the May 6 stock market plunge] and investors are suddenly asking themselves how should they respond, then they're doing the wrong thing," says Alan Wilson, president and co-founder of Talon Asset Management, which has $1.2 billion in assets under management.

Indeed. Diversification reduces risk in general, but specifically, investors must align their portfolios with their individual risk tolerance based on their goals, when they'll need the money and how much will they need. Diversification isn't a one-day, one-week or even one-month game plan that's turned on its head at the market's whim.

Managing Risk vs. Generating Returns

"Diversification is all about managing risk -- not returns," says Tim Kochis, chairman and former CEO of Aspiriant, which has more than $4 billion in assets under management. Unfortunately, many investors confuse diversification with maximizing performance.

Investors need to be diversified as a means of protecting themselves against market meltdowns. Long-term planning will allow for the fact that stocks don't go up endlessly -- there will also be periodic market routs, like the Dow dropping 487.69 points since Wednesday's close, shaving 4.5% off the index. Neither investors nor Wall Street soothsayers can predict the market's long-term behavior on a consistent basis, so a diversified portfolio helps smooth out the effects of hits and misses.

And while a number of personal finance advisers and asset managers may offer a risk assessment based on an investor's age, Kochis uses a different viewfinder to determine diversification needs: What are the most important goals, when will the money be needed to fund those goals and how much is needed?

Aggressive Portfolios Not Automatically Right for the Young

"A young person may have a conservative portfolio to save up for a house and can't accumulate a lot of risk," Kochis says. "An elderly person may have enough money for their needs, but wants to build up wealth for their children and grandchildren. That could be a 20-year time horizon, so they can have an aggressive portfolio," with the goal of achieving 10% returns.

Investors seeking an aggressive portfolio should have roughly 80% of their investments in equities (stocks) and the remainder in bonds, Wilson says.

When it comes to equities, Wilson believes investors should have 40% in emerging markets such as China, India and Brazil. In trying to pick winners in these regions, he further notes that investors should seek out companies that pay dividends, because it forces management to think long-term, rather than use free cash flow to survive.

Invest in Emerging Markets, Not Necessarily in Gold

Kochis is also a fan of foreign investments in emerging markets like China and Brazil, which demonstrate great opportunity for growth. He says investors shouldn't be frightened off by what they see overseas, especially in Greece, because the fundamentals of some emerging markets are strong.

Gold, however, is a less attractive investment to Wilson. He notes that the allure of gold in this market meltdown as a safe haven doesn't make sense for a portfolio in the long run. "In times of great stress, gold performs well," Wilson says. "But it only happens in intervals, and until it does, you don't see the returns."

Meanwhile, investors who plan to add fixed-income investments, bonds, to their portfolios should keep the maturity dates to no more than two years, tops, Kochis advises. "Unless the bond portfolio is actively managed, the bonds can still lose value even if they don't default," Kochis says. He notes that as interest rates go up, the value of the bonds decline and investors, if they're pressed for funds, may find it difficult to hold on to them.

For investors who are able to be more aggressive, bonds that are rated B, BB or BBB could be just fine, Wilson says, noting that they will be a little riskier than the A-rated bonds but carry higher returns.

Bond Investments Dwarf Mutual Funds

Bond funds have indeed performed well during the past 12 months, says Russel Kinnel, Morningstar's mutual fund research director. In fact, they've done well for most of this past decade. "Except for 2000, taxable bond funds have posted positive gains every year," Kinnel says. "It's been a pretty good decade for bonds."

Investments in taxable bond funds stand at $74.6 billion year-to-date and last year captured $287.5 billion, according to Morningstar (MORN). Compare that to U.S. mutual funds, which received an inflow of $189.3 million to date, an improvement over last year when the outflow reached nearly $26 billion. "People are starting to dip their toes back into stock funds," says Paul Larson, Morningstar's equities strategist.

One thing folks need to keep in mind during all the craziness is the old investor mantra: buy low, sell high. And that's difficult to do when one is following the pack.