Don’t Ignore Risks When Diversifying Portfolio

In the art of personal money management, diversification is considered one of the great virtues. But, like any other virtue, it can be carried to a fault.

Some analysts say that is precisely what has been happening lately as people seek new investment alternatives in an era of low interest rates and high stock prices.

Up to a point, they say, it makes sense to mix something like a high-yield “junk” bond mutual fund or an international bond fund into a portfolio of investments designed to produce current income.

Such vehicles usually offer higher yields than better-quality corporate bonds or U.S. Treasury securities--and at the same time may be less vulnerable to asset-value declines should interest rates rise in this country.

Similarly, a solid case can be made for extending stock-market horizons beyond American markets, to allow for the possibility that great growth opportunities may lie outside the United States.

But when the idea of diversifying is carried too far, it can turn into a self-deception, allowing the investor to take bigger gambles without acknowledging the hazards.

“In many cases, investors have tried to maintain their income levels by moving further out on the risk spectrum into offshore income investments and the like,” says Greg Smith, investment strategist at Prudential Securities.

“This necessity to take on ever greater risk in order to satisfy perceived or actual needs for income is ultimately a disturbing sign.”

In stock investing, meanwhile, many analysts worry that investors are buying funds operating in “emerging markets” nations, going on the false premise that these faraway markets are as well-regulated and liquid as the ones they are familiar with at home.

“I have no real quarrel with the long-term hypothesis that the economies of many emerging countries will offer the opportunity for better-than-average gains,” Smith says. “But keep in mind that phrase ‘long-term.’

“I believe many investors have been willing to take on more risk, sometimes rationalizing that it really represents diversification and therefore is not that risky.

“I’d argue that many of these emerging markets are every bit as risky today as they’ve been historically. On the way to a long-term positive result, some breathtaking dips could shake out many investors who thought they were in for the long haul.”

Michael Lipper, head of the mutual-fund tracking firm Lipper Analytical Services, questions the assumption that spreading money among stocks of various countries automatically provides a cushion.

International and global stock funds often are promoted with the idea that other markets might hold steady or rise as U.S. stocks suffer a setback.

But Lipper suggests that is far from certain. In seven of the past 10 years, he notes, U.S. general equity funds, world equity funds, and U.S. taxable fixed-income funds all have posted gains together.

So it would be no surprise for all of them to decline simultaneously at some point.

Much has also been made of the fact that international markets lagged behind the performance of U.S. stocks for the three years before 1993, when they at last rallied.

This does not certify all foreign investments as “cheap,” however. Standard value measures such as price-earnings ratios are high in most overseas markets--even in Japan, although stock indexes there stand at less than half their highs of four years ago.

To most experts, the first rule of investment safety is to diversify. But diversifying doesn’t eliminate the need to understand and manage risks.

If you buy lottery tickets in several different states, instead of just the one you live in, you can tell yourself you have a diversified portfolio. But you still are playing the lottery.