Plunge shows value of diversifying

The stock market returns for 2000 are in and the winner is...diversification.

As many investors painfully know by now, year-end results for the stock market in 2000 were not good. One year after the Nasdaq achieved a record-shattering 86 percent return, the technology-stock index suffered the worst decline in its history — just over 39 percent.

For the same year, the Dow Jones blue chips were down 6.2 percent, after five successive years of double-digit returns. The large-company Standard & Poor's 500 lost 10.1 percent, its worst showing since 1977. The Russell Index of small-cap companies lost 10.5 percent.

According to the mutual fund tracking firm Lipper Inc., the average diversified stock fund lost 1.67 percent in 2000. Mutual funds investing in tech stocks dropped 33.8 percent, and one Internet fund that had racked up a 273 percent gain in 1999 wiped out nearly half that gain in 2000.

On the other hand, real estate investment trusts (REITs), which invest in mortgages and commercial property such as hotels, apartments and warehouses, returned 25.9 percent after dismal years in 1998 and 1999. Mutual funds investing in REITs returned nearly as well.

A basket of U.S. Treasury securities of different maturities returned more than 13.5 percent, the best since 1995, according to Ryan Labs Inc. Value funds investing in mid-cap stocks returned 16.66 percent, and small-cap value returned 17.77 percent. The average bond fund — taxable and nontaxable — gained 7.7 percent, according to Lipper. And one of the benchmarks for the commodities market returned about 40 percent.

The change from the past several years, especially the dramatic decline in tech stocks, makes a strong case for diversification and asset allocation, said Dennis Filangeri, a certified financial planner (CFP) based in San Diego.

At its simplest, diversifying your investment portfolio means spreading your investment funds among a variety of assets: large company stocks, small company stocks, bonds, international (most of which didn't do well in 2000), real estate and cash. Exactly which asset classes you choose and what percentage of your portfolio you allocate to each class depends upon other factors on your investment goals, your tolerance for risk, and how much money and time you have to invest.

Diversifying your portfolio provides two major benefits: It reduces volatility (the swings between highs and lows), and it can improve your overall returns. Investment expert Roger Gibson demonstrated this in the March 1999 issue of the Journal of Financial Planning. He examined the returns from 1972 through 1997 of four equity asset classes: large-company domestic stocks represented by the S&P 500, large foreign stocks represented by the EAFE index (European, Australian and Far East stocks), REITs and commodities represented by the Goldman Sachs Group Inc.'s Commodity Industry.

He found that equity REITs, not the S&P 500, did the best of the four equity classes over the 25-year period. REITs not only had a higher return than the other three classes (14.01 percent compounded annual return), they also showed less volatility. The worst returning single-asset class was commodities, with an annual compounded return of 12.61 percent, with much more volatility.

This is not to suggest that investors should abruptly dump all large-company stocks, or even tech stocks, and only invest in REITs. After all, the Dow and the S&P 500 actually gave up only one-sixth of the returns they earned from 1995 to 1999. They'll do well again.

But because no one knows exactly when they'll do well again, it makes sense to diversify through different asset classes. Gibson found that when he began combining asset classes in portfolios of twos, threes and all four, returns started going up and volatility declined compared with holding any single-asset class.

"That's the power of diversification", says Filangeri. "Each asset class performs differently in different economic situations. Some are up one year, down another. It's when you combine them that they smooth out the ride and — over the long term — provide higher returns than rolling the dice on a single hot market area that could cool within months."

Zall, Bureaucratus columnist and a retired federal employee, is a freelance writer based in Silver Spring, Md. He specializes in taxes, investing, business and government workplace issues. He is a certified internal auditor and a registered investment adviser. He can be reached at miltzall@starpower.net.