Diversification eases stock losses but can't stop them

— -- You diversified your portfolio, spreading your risk between U.S. and international stocks, high-quality bonds and low-quality bonds. Your portfolio still got stomped.

Is it time to re-think diversification strategies?

No. But it's a good time to make sure you're really diversifying your portfolio — and that you're not making your diversification play into a core holding.

When you diversify, you spread risk among several different types of investments. And diversification is a good strategy.

Don't believe it? Ask someone whose entire retirement plan was in Bear Stearns stock. Or in Lehman Bros. stock.

"Puh-leeze," says Richard Thaler, professor of economics at the University of Chicago. "Any mutual fund is more diversified than the company you work for."

And while stock mutual funds fell a staggering 37.5% last year, many individual companies fared far worse, says Howard Silverblatt, senior analyst at Standard & Poor's. He counts 256 stocks in the S&P 500 that performed worse than the index — and that's just among companies that have survived. AIG, for example, tumbled 97.3%, and General Motors plunged 87%. Only a handful of S&P 500 stocks actually turned in a gain last year.

Worth the trip?

Clearly, holding a diversified stock fund is better than gambling on an individual stock. But what about other diversification plays?

Consider international funds, which have tumbled even more than U.S. funds. For example, the average international large-company core fund fell 44.5% last year, vs. 37.2% for the average U.S. large-company core fund. ("Core" funds are those that look for the stocks of growing companies selling at a reasonable price — a common stock-picking strategy.)

Going overseas brought you nothing but sorrow last year. Should you give it up as a strategy?

No, but perhaps you should tone it down, says Robert Doll, chief investment officer of BlackRock. "Correlations have moved up a lot."

Foreign stocks tend to move in lockstep with U.S. stocks these days — particularly when the markets are down. If the Dow Jones industrial average falls 500 points in a day, you can bet that Japan's Nikkei average is going to have a bad day, too.

But a good day in U.S. markets doesn't necessarily translate into big gains abroad.

International funds also pose an additional risk because of currency conversion. A fund that invests in French stocks has to value its holdings in dollars each day.

A rising dollar hurts a U.S. fund's overseas holdings, while a falling dollar helps it.

For example, suppose your fund had a stock that was valued at 100 euros per share. At the time, one euro was worth $1.40, so the stock sold for $140 per share. The next day, the stock was still selling for 100 euros per share, but the euro fell in value to $1.38. The fund's stock is now worth $138 per share.

Because the dollar rose last year, many international funds got a double whammy: falling stock prices and a rising dollar. For example, the German stock market fell 44.5% last year in euros. Figured in dollars, German stocks plunged 47.2%.

Emerging markets, another favorite diversification play, fared even worse. The BRIC countries — Brazil, Russia, India and China — were supposedly the hot growth countries.

But they plunged when the U.S. market tripped:

•Brazil, down 58%

•Russia, down 74%

•India, down 65%

•China, down 52%

If you still think international diversification is worthwhile, make sure you limit it to a set portion of your portfolio and rebalance when that allocation gets too high or too low. Most experts figure that about 20% of your stock portfolio — not your entire portfolio — should be in international funds.

Diverse at home

Being diversified doesn't mean holding two similar stock funds. In general, you should aim to own funds that have different investment styles — say, a bargain-hunting large-company fund and a red-hot small-cap growth fund.

Alas, U.S. diversification didn't help much last year, either. Large-company value funds fell 37.4%, while small-company growth funds plummeted 42.1%. Virtually all types of diversified U.S. stock funds fell an average 35%.

But some U.S. specialty funds have been touted as good diversifiers. Real estate funds, for example, tend not to be closely correlated to the broad stock market.

Unfortunately, real estate was at the heart of the credit crisis. Most real estate funds invest in real estate investment trusts, which, in turn, invest in commercial property — apartments, shopping malls and office buildings, for example. As the residential real estate market collapsed last year, Wall Street began to worry that commercial real estate wasn't in much better shape. As a result, the average real estate fund tumbled 39.9%.

You might reconsider real estate funds as diversifiers. Besides, says Doll, "If you own a home, you have enough real estate."

Another favorite 2008 diversification play: commodities. Several academic studies have suggested that the prices of metals and agricultural goods move in the opposite direction from stocks. Ideally, adding a small position in commodities will help cushion stock downturns.

Some commodities did that — just not as much as investors would have liked. Gold funds, for example, fell 28% last year. Diversified commodities funds fell 41%.

What to do

Don't expect that a diversified portfolio will keep you from all losses. Diversification eases losses, but it doesn't cure them. Realize, too, that last year's meltdown was the equivalent of a 100-year flood, a financial crisis the likes of which hasn't been seen for decades. "It's an extraordinary time," says Thaler. "We haven't seen a time when real estate prices have fallen at the same time all around the country and around the world."

Even many types of bonds — usually the most resilient defense against stock drops — got clobbered in 2008. A few junk-bond funds, which invest in low-quality, high-yielding corporate IOUs, fell more than 70% last year, as Wall Street worried about rising defaults.

Only Treasury securities were immune from the carnage. But now many experts figure that the Treasury market will be the scene of Wall Street's next sell-off. Should any type of investment seem more promising in the short term, the minuscule returns from T-bills will seem utterly unappealing.

Where will they go? Who knows? And that's one reason to spread your investment net wide. Use one or two broadly diversified stock funds as your core position, and add bonds to reduce your risk. If you think that commodities, gold, real estate or international stocks will help, add some of those, too. But add them sparingly — and if they soar, trim them back from time to time.