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The Best Remedy for Investor Insomnia

August 11th, 2010 |

Author: admin

The other reaction, however, would show great promise as an investor. And that would be to conclude, “Since no one sector of the economy dominates the stock market consistently, I need to put my money in a number of different companies, representing different sectors.” And you would be exactly right. You would have grasped the importance of “diversification” as a way to smooth out the ups and downs of the market.

Diversification is, indeed, a fundamental investing concept. A diversified portfolio helps keep investment returns on a more even keel — for example, when one sector of the economy is adversely affected by economic forces beyond its control. (Inflation can depress the price of financial sector stocks; political talk of price controls on drugs can adversely affect pharmaceutical companies.) And, individual companies can generate negative price pressures all by themselves. (Senior management may overestimate the popularity of a new product; a well-regarded CEO may abruptly depart.)

Being over-invested in a single sector of the economy, or a single company, threatens to significantly reduce investment returns, especially in volatile times. And no thoughtful investor wants to risk having the value of his portfolio fall sharply just before he’d planned to liquidate shares to make a down payment on a house, or pay for a child’s college education.

Diversification also works on a second level, and that is, apportioning your investments among “asset classes.” The three over-arching asset classes are stocks, bonds (or stock and bond mutual funds), and so-called cash-equivalent securities, such as money market mutual funds — so-called because they are quite safe and allow easy access to your money, much like cash. Investing in any of these securities carries some risk, but at varying levels. The level of risk is related to the investment’s potential return — another fundamental investing concept known as the risk/reward tradeoff.

Stocks are the most volatile and carry the most risk. They also offer the greatest opportunity for potential reward. Notice the word “opportunity” — not “guarantee.” Obviously the company or stock mutual fund must be well-managed over the long term to meet this potential. Bonds are more stable and carry lower risks than stocks — but also, on average, lower investment returns. And, since a cash-equivalent security such as a money market mutual fund is typically invested in high-quality Treasury bills, it provides the safest place for your money, and — true to the risk/reward tradeoff — also the lowest return. While this safety may appeal to you, a low return on too-large a share of your portfolio is unlikely to provide adequate protection against erosion in purchasing power due to inflation.

Asset allocation is predicated on the theory, backed by a number of academic studies, that by holding a balance of investment assets over the long term, shareholders reduce risk and increase the likelihood of achieving solid investment returns. For example, a dip in the value of some of the stocks in your portfolio can be balanced by more-stable bond performance. And having a share of your investment assets in a cash-equivalent product means that if you have an unexpected financial emergency, you will have the funds to meet it, without being forced to sell shares of stock at a time when the market may be down.

As we enter the new millennium, diversity and its risk-lowering properties deserve a closer look. Many analysts believe we’re entering a more volatile — and therefore riskier — investing climate than that of the steadily rising market of the 1990s. Finding your personal comfort level for volatility and potential losses, noted a recent Wall Street Journal article devoted to risk, is part of “an age-old quest for balance. Investors who structure their portfolios so that they are comfortable with both the rewards and risks are the ones who sleep best when market downdrafts keep others awake at night.”

In other words, investment diversification is the best remedy for investor insomnia.

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