Guest Column: Even amid recession, diversification minimizes risk

The wise person who coined the adage, "Don't put all your eggs in one basket," probably didn't know about the equity basket, corporate bond basket, mutual fund basket, money market basket or myriad other investment baskets.

Diversifying assets among a number of baskets makes sense when the market is healthy. But when all sectors, industries and investment options slump, it is easy to rationalize moving what's left of those eggs into one basket and holding on for dear life.

Alleviating risk

Diversification and asset allocation are principal tenets of basic investing. Properly spreading assets among different types of investments minimizes the risk of one investment sabotaging the whole portfolio. Unfortunately, what investors have experienced for the past 12 months has been systemic, or market, risk - the overall risk of participating in the market system. No amount of diversification will protect an investor from this type of risk.

What proper diversification will protect against, however, is not systemic risk, but the risk that individual stocks will fluctuate.

The chances that an individual company, industry or sector will slump are a lot greater than the market as a whole crashing, so protecting a portfolio from such risk is as important now as it ever was. But the bigger issue is figuring out the proper diversification and allocation to match the overall goals of an investment plan.

Pursuing a plan

Behind any good portfolio, there is a plan that includes the objectives, time horizon and risk tolerance of the investor. To properly diversify a portfolio, the investor has to know how long this money has to work, what its final purpose is and how much is needed when the time comes to use it. These elements will tell an investor if they need to add some higher risk - and usually higher return - investments or diversify among safer, more fixed-income options, with a typically lower return.

Consider these factors for proper diversification:

• Time horizon and risk tolerance. An investor could own a number of great investments, but if those options don't match the goals of the portfolio, it will only hurt the investor in the long run. For example, if the investor is five years from retirement, capital preservation is extremely important, and exposure to the stock market should be limited.

• Low correlation. It's important to choose sectors and classes that tend to move independently of one another. For example, the factors that impact the financial sector of the stock market often also affect industrial services. Owning a lot of stock in those two sectors won't alleviate much risk.

• Mutual funds are a great way to add diversification, but they need to be taken in context with other investments already in the portfolio. Many mutual funds are sector-specific, so be sure that fits well with the overall objective.

Gone are the days when an investor could add a few mutual funds and some AAA-rated bonds to a portfolio and be set for a decade or two. Keeping the overall investment plan updated and rebalanced is critical.

Marriage, children, fluctuations in income and, of course, impending retirement, impact the goals of a portfolio, and change its focus. A newly married couple with two steady incomes may be more concerned with growth and be more willing to ride out a few bumps. Their diversification will look a lot different from those of a couple who plan to retire in five years and need the security of long-term risk-control.

While diversification does not guarantee that a portfolio will not lose value, it is one of the most effective ways to lower the chances of such losses occurring. Done properly and with overall investment objectives in mind, diversification and asset allocation may still save a portfolio from long-term ruin.[[In-content Ad]]Jami Peebles is a senior vice president with Central Trust & Investment Co. in Springfield and a certified trust and financial adviser.