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The Value Of Diversification
by Peter Passell

You've heard the speil umpteen times: don't put all your investment eggs in one basket. This is common sense--baskets sometimes leak. But it's also solid, sophisticated economics.

Diversification creates opportunities to reduce risk without reducing the expected return (and vice versa). That's why professionals always recommend that small investors buy a broad range of investments--for example, buying mutual funds that own multiple stocks rather than buying a handful of individual stocks on their own.

But diversification is a little trickier than you might think. If the bad news that could affect one investment equally affects another, buying both won't generate the something-for-nothing benefits of true diversification. The current financial crisis we've just experienced suggests that some kinds of bad news can adversely affect virtually every investment possible.

Think about it. First housing prices began to fall, dragging down the value of companies that build houses, finance them, and insure their mortgages. But the holdings of mortgage-related securities were so widespread (and the risks so poorly understood) that the housing bust devastated huge swaths of financial services industries in Europe as well as in the United States.

The resulting credit crunch threatened all sorts of businesses on every continent, cratering stock prices in Brazil, India, Russia as well as the United States.

This doesn't imply that investors should stop bothering to seek diversification. But it should make them seek diversification in less familiar places--for example, in government securities denominated in foreign currencies.

More generally, it should make them more cautious in relying on diversification to contain risk. The bottom line: now, more than ever, most investors need a rock-solid core of virtually riskless assets in their portfolios.

More on diversification and other tips on investing in today's volatile economy can be found in Where To Put Your Money NOW by Peter Passell.

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