Money Matters
Spreading the Wealth
by Brad Zigler

In the inaugural Money Matters column, three criteria were laid down for building a lifelong investment portfolio. The recent market meltdown points out the strength of our primary principle: "You'll probably need more than one fund to fill out your portfolio. More than one, but probably not more than six."

What we're talking about here is diversification. You know, mixing things up a little to create a workable whole that's better than just an assortment of disparate parts. Like trying to create a killer outfit from the clearance items at Macy's.

Jeez. I can't believe I wrote that. But here's the point: holding more than one kind of investment (or "asset class" in the parlance of moneyed fashionistas) allows you to maintain your footing on the catwalk that is the economic cycle. Stocks and bonds, for example, are different. With stocks, you "own" a chunk of a company. That gives you the same risks as any proprietor: There's no guarantee you'll get your money out of the company or, in fact, earn anything on your investment if the company fails to attract customers, mismanages its finances, or is forced to weather a faltering economy. A recession, for example, may discourage customer purchasing, dimming the prospects for company earnings which, in turn, will likely depress its stock price.

Bonds, on the other hand, may appear immune from the effects of a relatively mild recession. The reason for that? A bond isn't an ownership interest. Instead, it represents a loan made to the issuer. Bonds promise a payback of the original loan amount and, in most cases, regular interest payments at a prescribed rate. If the issuer is otherwise a good credit risk—the U.S. government is the top credit and bond issuer—an economic slowdown could actually make a bond more valuable. Investors, after all, will be attracted to the promise of reliable, regular income, especially when other income opportunities seem iffy.

The fact that these securities respond differently to economic developments is evidence that they aren't perfectly correlated with one another. And that makes them good candidates for mixing together into a portfolio. Financial pros have long known that combining assets with different sensitivities reduces overall portfolio risk while still providing an upside. Simply put, the object of allocating portions of your portfolio to different kinds of assets--putting zigs together with zags—is to smooth out the bumps in the economic road. With investments, having too much of even a good thing can turn out bad. Concentrating a portfolio in a single asset class can actually increase risk.

Consider this: historically, stocks produce the highest average annual return of any investment—about 11 percent. That's not to say that equities earn 11 percent each and every year, though. Some years, stocks gain big; in others, they lose big. Balancing a portfolio with different kinds of investments—putting stocks together with bonds, for example--gives a portfolio staying power by smoothing out the effects of naturally occurring cycles. When the economy's humming along, a portfolio made up of 100 percent stocks will outdo an account that contains nothing but bonds. In a recession, though, the opposite holds true. Mix stocks and bonds together, though, and you end up with a portfolio that doesn't swing so widely in value as the economic winds shift. The value of your portfolio may not go up as high in a given year when one type of investment is favored, but it'll probably not decline as much when an investment is out of favor, either.

That's important because the aftermath of a loss—the recovery—is a very real challenge for an investment account. To get back to break-even, recoveries need to be bigger than the preceding losses. Clawing your way back from a 20 percent loss, for example, requires a subsequent 25 percent upside move. Why's that? Well, think of it this way. If you started with $100, then lost 20 percent, or $20, you only have $80 to put to work. To get back to your $100 starting point, you'll need that $80 to produce a $20 return. $20 divided by $80 is 25 percent, right? Likewise, you'd need a 100 percent bounce to recover from a 50 percent hit (a $50 recovery earned on a $50 capital base is 100 percent).

Here's the lesson to be learned: you'll need geometrically larger recoveries to overcome growing setbacks. And, when you consider average annual returns, you now have an idea how long your recovery can take. A 20 percent loss could take two years to overcome if your portfolio was made up of stocks. It could be a decade before you get back to breakeven after a 50 percent hit on an all-stock portfolio. If you minimize drawdowns in the size of your account, you don't have to ask so much from the market. Combining uncorrelated assets—mixing the zigs with the zags—can do just that, allowing you to lose less, and keep more, compared to an undiversified portfolio.

So, how many zigs and zags does your account need? We'll look at the asset classes that financial pros use to build well-diversified portfolios in upcoming columns.

Brad Zigler, in a former life, headed up marketing, research and education for a securities exchange and for an investment management firm. He now writes and edits for a number of financial publications and is a brand-new ASJA member.