Diversification Isn't Dead; It Just Needs Tweaking

Diversification hasn't paid off recently, but that doesn't mean investors should abandon the practice.
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Remind me again why I own small-stock, value and international funds? Oh, right, so I can be diversified. OK. Remind me again why I want to be diversified?

The only thing a diversified portfolio has done for investors lately is keep them humble. Sure, during Monday's

Nasdaq

selloff, less tech-heavy investors might have gloated. But the Nasdaq quickly bounced back, and diversification is once again looking like a tired concept from the past.

I know you don't want to read yet another lecture on the virtues of reducing your risk while everyone around you is cashing in on a relatively small number of stocks. But as we'll see, there is a middle ground.

Judging from the money flows, most of you are more interested in bragging rights than in humility. You have been loading up on the top-performing index and large-growth funds and shunning -- or dumping -- the underdogs.

So far this year, large U.S. growth funds have taken in $10 billion, while large value funds have lost $6.6 billion and small-stock funds have lost some $5 billion, according to

Financial Research Corp.

, a Boston mutual fund consultant. Global equity funds lost $31 million.

Now jump back to 1997: Small-stock funds took in nearly $30 billion (for the full year) and large value funds collected a whopping $46 billion, while large growth funds squeezed just $14 billion out of investors. Global equity netted $108 million.

Obviously, recent returns, or lack thereof, are changing a lot of investors' asset-allocation strategies.

"Diversification is a hard sell right now," says financial planner Chris Cordaro in Chatham, N.J.

Just last August, Cordaro recalls "pleading, cajoling and begging" clients to stay in emerging-markets funds. Those he persuaded are enjoying a 30% comeback, Cordaro says. Those he couldn't convince sold out at what is looking like a pretty convincing bottom. Time and again, history shows investment styles and asset classes rotating in and out of favor, at random, as this table suggests.

A portfolio equally divided among these asset classes would have returned 15% a year from 1972 on, beating the returns of all the single categories except international small stocks, which turned in 16% a year. (U.S. large stocks returned 13.8%.) "I'm more comfortable betting on five horses and coming in second or third than betting on one and coming in last," says Cordaro.

Investors who load up on recent winners at the expense of laggards are actually committing two sins against conventional investing wisdom: They're not diversifying, and they're chasing performance. The latter has typically translated into buying high and selling low.

Studies by

Morningstar

, Financial Research Corp. and others have found that top-performing funds rarely maintain their winning ways in subsequent time periods, and that "hot" mutual fund money consistently underperforms a disciplined, dollar-cost-averaging approach.

Whether they're chasing winners, neglecting laggards or both, investors are increasingly practicing "rearview mirror" investing, say the old-school scolds, which is as dangerous to your portfolio as navigating a car by looking behind you.

"I've been accused of rearview-mirror investing," says Minneapolis money manager Robert Markman, who runs several funds of funds with a growth bias. "But

they're

the ones with the rearview mirror," he says of his critics. The diversification mantra may have more to do with what the fund industry has to push than with what the investor needs to own, he suggests.

Markman makes no apologies for his blue-chip bias. (Why would he? His

(MMAGX)

Markman Multifunds Aggressive Allocation fund is up 28% for the past 12 months vs. 18.5% for the

S&P 500

.) He continues to favor concentrated growth funds such as

(MFOCX) - Get Report

Marsico Focus,

(JAVLX)

Janus Twenty and

(WOGSX) - Get Report

White Oak Growth Stock, all of which have been hit hard in the past week's tech selloff. He also likes to leverage the S&P 500 with

(RYNVX) - Get Report

Rydex Nova, which tries to better the benchmark with futures and options.

Value funds? "It's hard to take a value approach and have both feet in the 21st century," Markman scoffs. Nor does he mince words when it comes to emerging markets: "If you think you have to go to Bangkok to diversify, then you need a psychiatrist, not a money manager. I've burned my passport, financially speaking."

Markman -- and his numbers -- can be pretty compelling. Remember our equal-mix portfolio? Measuring from 1982, large U.S. stocks trounce it, returning 17% a year while a diversified mix of assets earned just 14.2%.

So why am I not ready to abandon the conventional wisdom about diversification? Because days like last Monday are a reminder of what could happen in a full-scale rotation. I'm with Sheldon Jacobs, editor of

The No-Load Fund Investor

newsletter. It may sound wimpy, but I think a middle course between conventional wisdom and new-era strategy is the way to go. Jacobs says, "I can't give up on diversification," but he does tweak the principle a little bit.

Leadership trends do appear longer-lasting these days, Jacobs says. Consequently, he has overweighted large-cap U.S. growth in his model portfolios and in his money-management business. He has "de-emphasized" small-caps, but won't eliminate them entirely. He's cut back on pure value plays, but added index funds with value components. As I do, he believes "value could come back, perhaps soon."

Here's where Jacobs and I differ: He has dropped real estate as an asset class. (I wish I had, but I still own

(FRESX) - Get Report

Fidelity Real Estate shares -- arghhhhhh!) He has, if only temporarily, dropped emerging markets as an asset class. (I don't own any but wish I did.)

The middle ground may not carry the weight of conventional wisdom or the excitement of new-era convictions. But the approach is profitable.

No less than

The New York Times

anointed Jacobs fund-picker of the quarter, with a 4.56% return on a hypothetical retirement portfolio constructed for the paper, compared with a 1.16% return for domestic stock funds on average and 4.98% for the S&P index. Not gangbusters maybe, but not shabby, either.

Anne Kates Smith is a senior editor at U.S. News & World Report in Washington. At time of publication, she owned shares in the Fidelity Real Estate fund, but positions may change at any time.