Complain about a product or service

Stock Market Making You Sick?

Take a Diversification Pill and Call Us in the Morning

By Fred Yager
ConsumerAffairs.com

March 7, 2007

Personal Finance • When Should You Sell Exchange Traded Funds? • A Gloom and Doom Week Ends On a High Note • Has the Bear Market Hit Bottom Yet? • How Do You Survive a Bear Market? • Supreme Court Upholds Right To Sue 401(k) Administrators • Retirees May Face Unexpected Lifestyle Changes • Survey: Americans Not Saving Enough • Money Market Funds: No-Brainer, or No Brains? • Two Bear Stearns Hedge Funds Go Broke • UBS Pays $23 Million to Settle NY Charges It Misled Clients • Supreme Court Deals Investors Another Setback • Supreme Court Rejects Investor Claims --- • More Personal Finance News

Investing in the stock market these days is like sailing on a stormy sea and it's just as likely to make even a veteran investor a little queasy.

While seasick pills may ease the nausea caused by rolling waves, a healthy dose of diversification is the treatment most often prescribed by financial doctors to weather the kind of turbulent stock market ups and downs we've been experiencing lately.

Volatility seems to have settled over the stock market like a tropical storm. In the past week, the Chicago Board Options Exchange (CBOE) saw its Volatility Index (VIX) nearly double. The worst position to be in when this happens is to be invested a single stock or security because they tend to go up the highest and down the lowest on a percentage basis during periods of wide market fluctuations.

To continue our nautical comparison, having all your savings in a single stock would feel like being in a rowboat during a hurricane. But if you had your money in a number of different securities it would feel more like being on an ocean liner.

Both vessels would go up and down the high waves but the ride on the larger ship would be a whole lot smoother.

Unfortunately, there are millions of Americans who fit into the "rowboat" profile. They have all their eggs invested in one or two baskets, often in the stock of their employer. And when situations like the latest one-day 400-point drop in the Dow Jones Industrial Average occurs, they suffer the most because when the Dow drops four or five percent, their stocks go down a lot more.

Diversify, Diversify

Financial advisors agree that the best way to protect your investment savings against such volatility is through diversification. Even Jim Cramer, the super-charged host of the popular CNBC television show "Mad Money" has a segment on his program called "Are you Diversified?" where he analyzes callers' portfolios to determine if they are truly diversified.

What is diversification anyway? Simply put, it's a way of managing your risk of exposure by spreading your savings and investments among a variety of different securities that move independently of one another.

There are many ways this can be achieved.

If you want to keep all of your money in the stock market you can diversify by owning stocks in a variety of industry groups, such as retail, food and beverages, utilities, financial services, and energy. Or you can also invest in bonds, commodities and Exchange Traded Funds or ETFs which invest in combinations of securities that may not be connected to the stock market such as oil, gold and foreign currencies.

There's sort of an unwritten consensus among some financial advisors that at least 30 stocks from several different industry sectors are needed in an equity (stock) portfolio in order to be truly diverse. But Burton Malkiel, Princeton Economics Professor and author of "A Random Walk Down Wall Street," recommends even more. He says you should have a portfolio of at least 50 U.S. stocks and another 30 to 50 foreign stocks.

Index Funds

According to Malkiel, one of the best ways to achieve that is through index funds. An index fund basically mirrors a market index such as Standard & Poor's Index of 500 stocks. This is also known as passive investing and it is often criticized by some as being a rather dull way to play the market. But when things get too exciting such as they have been lately, a little dullness could be a welcome relief.

A key advantage of an index fund is that not only will you not miss the next market rise you also won't lose as much the next time the market drops. They also tend to be less expensive because there are no "active" management fees.

The fact that index funds have no active manager during times of intense volatility is one argument against not putting all of your money into them. Many financial advisors believe you need an experienced money manager at the helm when the markets start to fall so sharply.

Financial advisors recommend that before just going out and buying a bunch of securities, set up an asset allocation strategy based on your own investment goals and risk tolerance and then just stick to it.

This isn't always easy to do. Especially, if in order to remain truly diversified, you have to sell some stocks that are still going up. Others find it hard to sell stocks that have come down because it means they're going to take a loss. In either case, you have to consider the alternative of not being diversified which could far outweigh any short-term loss you might suffer from the sale of one security.

Risks vs. Rewards

Two other things to consider when putting together a diversified portfolio are risk and reward and the right balance between them.

For example, let's say you own some mutual funds and are considering adding one more to your portfolio in order to make it more diverse. You would look at the fund's return to see if it would raise or decrease your portfolio's average.

Then you look at the risk. Will it increase or decrease your exposure to risk? If the new fund increases your overall portfolio's return without contributing too much additional risk, it may be worth taking it on.

Figuring this out on your own might be more than you can handle. That's why we recommend finding a knowledgeable and reputable financial advisor to help you put together an effective diversification strategy. Unless you know and trust a financial advisor personally, we would also recommend seeking out one of the larger and well-known financial services firms.

It may be too late to undo your losses related to this most recent major dip in the market, but diversifying will at least protect you the next time the sea starts to churn.

Report Your Experience
If you've had a bad experience -- or a good one -- with a consumer product or service, we'd like to hear about it. All complaints are reviewed by class action attorneys and are considered for publication on our site. Knowledge is power! Help spread the word. File your consumer report now.

Back to the top |