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08-30-2005, 08:09 AM
August 28, 2005
The Long-Term Lesson: It Pays to Diversify
By JONATHAN FUERBRINGER

SINCE 1994, every financial market has had a major stumble that has cost American investors caught on the wrong side a lot of money.

In 1994, bonds had their worst year in the last three decades. In 1997 and 1998, and again in 2001, commodity prices took a nose dive. In 2000, stocks plunged into a three-year bear market.

I was around for all of those stumbles - and tripped up a few times myself when musing about stocks, bonds, commodities and the dollar. Calling a fall in stocks in the 1990's was easy, except that they didn't drop until several years later than predicted. The bear year in bonds was as unexpected as it was unpleasant.

The markets have also surprised on the upside. Look at the much-better-than-expected returns from bonds in the three years through 2004.

Some analysts in 2002 were worried about looming interest rate increases by the Federal Reserve. Like the stock market, however, the Fed delayed its move for years. When it did start raising short-term rates, in 2004, longer-term yields fell anyway.

Commodities - not just oil, but also raw industrial materials like copper and precious metals like gold - have had a multiyear run that has surprised many investors.

The lesson here is not that analysts, strategists and financial reporters are often wrong. That's well documented, even by this column, which is taking a leave of absence for the next year or so.

The lesson is that stumbles and recoveries are inevitable, and that means diversification is a very good idea. It increases the chance that something in your portfolio is going up when other portions are going down. In fact, diversification has produced much better results than many investors may think.

I don't mean diversification within a stock, bond or commodity portfolio. I mean diversifying among what Wall Street calls asset classes, so that your portfolio holds stocks, bonds and commodities.

Diversification among asset classes also makes you put money where you may otherwise fear to go. And who knows? You may get a sweet surprise.

In 2003 and 2004, I kept my 401(k) in a money market fund - which is more like a mattress than an asset class - because I was sure that interest rates would rise and I wanted to avoid the resulting capital losses in the bond market. I would have done even better if I had also moved some of that money into a 401(k) stock fund.

Diversification also prevents stock mania from distracting you from the opportunities in other asset classes. Stocks are right for the long run, as Prof. Jeremy J. Siegel of the Wharton School of the University of Pennsylvania has argued for years. But stocks are not the be-all and end-all of a good portfolio. The recent big gains in commodities are the best example of that.

Over the last 3, 5, 10 and 15 years - the usual investment horizons for measuring market performance - only stocks have had a down period. The average annual total return for the Standard & Poor's 500-stock index was a loss of 2.3 percent in the five years ending in 2004, according to data calculated by Ibbotson Associates.

Bonds had an average annual total return of 7.7 percent over the same period, as measured by the Lehman Brothers (http://www.nytimes.com/redirect/marketwatch/redirect.ctx?MW=http://custom.marketwatch.com/custom/nyt-com/html-companyprofile.asp&symb=LEH) aggregate bond index. Commodities, as gauged by the total return of the Goldman Sachs (http://www.nytimes.com/redirect/marketwatch/redirect.ctx?MW=http://custom.marketwatch.com/custom/nyt-com/html-companyprofile.asp&symb=GS) Commodity index, produced returns of 13.8 percent, annualized.

I am not anti-stocks, especially for the long run. Over the 10- and 15-year periods through 2004, equities were the winners. They returned 12.1 percent, annualized, over 10 years and 10.9 percent over 15 years.

Bonds had annualized returns of 7.7 percent in both periods, while commodities brought home 9.1 percent a year, on average, over 10 years and 7.1 percent over 15 years.

The average annual returns from money market funds were much smaller: 1.6 percent over three years, 2.8 percent over five years, 3.8 percent over 10 years and 4.4 percent over 15 years, according to iMoneyNet.

Diversification is also a benefit, of course, when one big asset class stumbles and another picks up. Looking for such lead changes keeps investors sharp.

WHAT makes diversification unappetizing is that you would not have racked up the huge returns that stocks alone brought in the late 1990's - or the big gains that commodities brought in 2002 through 2004. But you would have done a lot better with a diversified portfolio than you might have expected.

Over the three years through 2004, according to Ibbotson Associates, the average annual return from a portfolio containing all these asset classes was 7 percent, assuming that you held 55 percent stocks, 30 percent bonds, 10 percent commodities and 5 percent cash. That compares with a return of 3.6 percent for a portfolio containing only stocks.

Over five years, the average annual return was 3.4 percent for the diversified portfolio, versus an average annual loss of 2.3 percent for stocks. Over a longer period, a stock-only portfolio fared better, but not by much. The annualized 10-year return for stocks was 12.1 percent, versus 11 percent for the diversified portfolio. Over 15 years, stocks won by only 10.9 percent to 10 percent.
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