Opinion: Portfolio diversification rules apply to businesses

Imagine what the HVAC business owner’s company would be like if he sold and installed only furnaces: pretty bad in the heat of the summer. There must have been a lot of excited HVAC guys back in the 1950s when air conditioning started becoming more affordable and available for small businesses and homeowners. At last, a product that provided income during the traditionally lean spring and summer months.

He had a business model at that point that kept the cash register ringing by selling and servicing products with marketability at different times of year. Bingo – a business with noncorrelated products! When one was out of favor, the other was in favor.

So it is with proper asset diversification in an investment portfolio. The attractiveness and performance of investments of various styles and capitalizations is not a constant. One year it might be large-cap growth stocks, the next small-cap value or international or bonds or real estate. You can absolutely count on this: No single style or capitalization will always be the best performer of the year.

What style will be the big winner over the next 12 months? Beats me. It can be, as it usually is, a fickle marketplace. The pundits on Wall Street have their theories based on oil prices or inflation or politics or whatever, but they do not know any more than you or I know. The market is, by definition, unpredictable. What exogenous event could send the market reeling or skyrocketing? Again, beats me.

That’s why we continue to recommend a broadly diversified portfolio of assets with limited correlations. But what we recommend and what we frequently see are two different creatures. Here’s an example. Earlier this year a prospective client showed us his current holdings, consisting of three mutual funds that he had chosen as a means of diversifying his investments. Because they were from three different mutual fund companies, he felt that he had achieved diversification. But he was not happy with the total return they provided in 2005.

His problem was one of not being diversified. His largest holding was in Washington Mutual, followed by smaller positions in Fidelity Equity Income and the Vanguard 500 Index.

He could have checked out free information on the funds via the Internet, in which case he would have observed that there were significant duplications of issues held among the 10 largest positions of the three funds. In effect, he was overloaded in large-cap stocks that were primarily value-oriented. The absence of other styles and capitalizations penalized his performance. Especially noticeable was the omission of any foreign holdings, an area he said he wished he had held positions in.

He had given diversification a shot in his opinion. At least he tried, which is more than many do.

So what does that mean for you? Your financial consultant should be able to help you design a diversified portfolio that provides an asset allocation that is appropriate for your risk tolerance. You can take a shot at doing it yourself and may be able to find a satisfactory system on the Internet that will help you construct your portfolio. (You’ll have to be patient though, there are more than 25,000,000 hits if you Google “asset allocation.”) I suggest working with a professional, as the human interaction will often help delve more deeply into your concerns, goals, and rationale for investing – something most of us don’t fully explore.

Holiday investments

Let’s shift gears. We are wrapping up the third quarter of the year and will shortly be heading into the best selling season for retailers. Back-to-school sales were above expectations. We think that the Christmas season sales also will be above current predictions. We do not base our investment decisions on short-term or seasonal ups and downs, but if you have been putting off making investments because of the “sell in May and go away,” bromide, you might want to loosen your investment purse strings now. Here’s one way to get started: Ask yourself where you did most of your shopping last Christmas season and how busy those stores were. Target? Best Buy? Dillard’s? Penny’s? Wal-Mart? Then run your screens.

Clark Davis is a 37-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company. He can be reached at cdavis@slia.com.[[In-content Ad]]