Diversification Isn't Dead

Let's say it's 1999, and you're kicking back in front of the TV, flipping through the channels to watch the latest hit show (Who Wants to Be a Millionaire?), the most popular music video (Ricky Martin's "La Vida Loca"), and some new cartoon about a sponge with square pants. Over on CNBC, they're marveling, in a somewhat self-congratulatory tone, that the Dow Jones Industrial Average has crossed the 11,000 mark.

Then -- poof! -- your future self appears next to you on the couch. "Hi, I'm you, just 10 years from now," your older self says to you. Your first reaction is: Dang, I never lost that extra 10 to 15 pounds. Drat you, Fen-phen!

But you soon recover and think, What a great opportunity -- I'm going to find out all that's going to happen over the next decade! "So," 1999 you says to 2009 you, "what are some of the big surprises over the next 10 years?"

"Well," 2009 you responds, "that governor from Texas who just announced his candidacy for the presidency -- the one with the same name as a past president -- will get elected twice, though it'll take more than a month for the first election to be officially and controversially decided. Then in 2008, an African-American is elected president. And you'll never guess who's the governor of California! I'll give you a hint: He played Mr. Freeze in the recent Batman movie. Oh, and Stuart Smalley (a.k.a. Al Franken) is a U.S. senator."

From there, you hear about the Sept. 11 attacks and subsequent wars. You'll learn names like Elian Gonzalez, Daniel Pearl, and Hurricane Katrina. You'll be wowed by tales of cell phones that act like little laptops and don't need to be plugged into the phone jack to access the Internet. You'll find out that Walter Cronkite outlives John F. Kennedy Jr., Anna Nicole Smith, and Michael Jackson. You'll be told of the demise of Enron, WorldCom, Montgomery Ward, Lehman Brothers, Merrill Lynch, Fannie Mae, Bear Stearns, and many others.

It's at this point that you, being an investor and all, will get a clue to some very surprising news: The Dow will be 20% below its 1999 price level.

"We walk every moment into the unknown"
Would you, back in 1999, have been able to predict any of those events? Of course not, and neither could anyone else. In the words of Yogi Berra, "It's hard to make predictions, especially about the future."

Someone else who passed away since 1999 (though relatively recently) was Peter L. Bernstein, author of such investing classics as Capital Ideas and Against the Gods: The Remarkable Story of Risk. He died on June 5 at the age of 90. He had seen it all. A child of the Depression, Bernstein wound up attending Harvard with John F. Kennedy, serving in the Air Force during World War II, working at the Federal Reserve, and managing billions of dollars during the 1950s and 60s. He was on a first-name basis with most of the biggest brains in finance -- including several Nobel Prize winners. Bernstein began publishing his Economics and Portfolio Strategy journal in 1973, and he wrote 10 books -- five after he was 75.

Surely someone of Bernstein's vast intelligence, experience, and connections would have some confidence about being able to predict where markets are headed.

Well, no. If fact, during a January 2008 interview with McKinsey Quarterly, Bernstein explained his theory of risk: "I believe with a passion ... that we don't know what the future holds. We walk every moment into the unknown ... What risk management really means [is that] things are going to be different from what we expect from time to time, and how well prepared are we to deal with it when it is different?"

In an unpredictable world, how should someone invest? In an interview for my Rule Your Retirement service, this was Bernstein's advice: "In my own portfolio, I am essentially buy and hold. I make occasional changes, but I am not out there trying to beat anybody or beat anything because I know I can't ... I am very diversified ... Diversification is not a passive strategy. It is an aggressive strategy because unless you are fully exposed, you may miss the big winner. It isn't just trying to protect against loss; you also want to be sure you are exposed to opportunity."

Buy and hold. Diversification. Good old asset allocation. After decades of dissecting the capital markets, that was Bernstein's recommendation.

Diversification is not dead
"But asset allocation doesn't work anymore," you may be saying -- and you wouldn't be alone. Here's a blurb from a recent Wall Street Journal article: "Asset allocation, a bedrock of investing for decades, appeared to fail miserably in 2008. The conviction shared by most investors -- that they should spread their money across myriad asset classes to minimize losses -- was shaken as nearly all markets tumbled in unison."

There are two glaring problems with these claims of the death of asset allocation. First, an investment strategy should not be judged based on just one year's performance. That's the mistake made by the lemmings who piled into the Nasdaq in 2000 after it returned more than 80% in 1999; they're still down more than 60%.

Second, asset allocation did work in 2008. Anyone who diversified into bonds, Treasuries, or cash was better off than someone who just owned stocks.

Let's put these two together by looking at the returns of the S&P 500 over the past decade, using the Vanguard 500 (VFINX) as a proxy, and compare it to the "Within 10 Years of Retirement" model portfolio in my Rule Your Retirement service, which is 30% bonds and 70% stocks of all sizes, styles, and nationalities.

Source: Morningstar Principia software. *6/1/1999-5/31/2009, portfolio annually rebalanced.

No, the diversified portfolio didn't spare investors from the worst carnage since the Great Depression, but it cushioned the blow. Plus, by holding all kinds of bonds and stocks from all over the world, it actually made money over the past decade, which the S&P 500 did not.

Dealing with the unknown
Unfortunately, we can't consult our future selves for investment advice. And unless you've perfected the crystal ball, investing based on a prediction of what handful of stocks, funds, or assets will beat the others over the next year has a very sorry record. Thus, in an unstable and unpredictable world -- where decades-old firms can fail, a handful of fanatics can drive nations into war, and comedians run the country -- a well-diversified, intelligently allocated portfolio is the way to go.

To intelligently incorporate asset allocation into your portfolio, take a 30-day free trial to Rule Your Retirement.

As a kid, Robert Brokamp met Frank Gorshin, the Riddler from the original Batman TV show. He also owns shares of VFINX.  Netflix is a Motley Fool Stock Advisor recommendation. Pfizer is a Motley Fool Inside Value selection. Johnson & Johnson is a Motley Fool Income Investor recommendation. Novartis AG is a Motley Fool Global Gains pick.