Saturday, October 18, 2008

Advice for Today's Market? Diversify Wisely

Advice for Todays Market? Diversify Wisely

As of Oct. 7 retirement plans had lost as much as $2 trillion over 15 months, or some 20% of their value, according to the Congressional Budget Office. That has many workers wondering how they'll be able to retire and whether everything they thought they knew about investing has been turned on its head. Diversification across sectors and countries, for example, was supposed to protect investments, but few areas of the market have been spared. And what future returns can be expected from stocks and bonds? Have all of our rules of thumb gone out the window? We asked Jack Bogle, founder of fund giant Vanguard Group and a pioneer in the investment indexing business; and Zvi Bodie, a finance professor at Boston University School of Management, co-author of the leading finance textbook Investments and an expert on retirement security, to discuss issues facing savers and investors today. Christopher Farrell launched a discussion between the market veterans by asking if diversification remains a bedrock strategy. The conversation has been edited and condensed.

Jack Bogle: I am a believer in diversification. You buy index funds for stocks, and your bond portion should equal your age. This is how I invest, so I know how little it's hurt me to have a substantial position in U.S. bonds. I'm in half Treasuries, half corporates.

The most common diversification talked about is international. What's wrong is that as soon as people start really talking about it and believing in it, international stocks are overpriced. About 80% of money going into equity funds last year was going into international. If that isn't a warning sign! Here we are: The U.S. is one of the better-performing world markets. From the market peak in 2007, the S&P 500 is off 42.5%, international [measured by the MSCI EAFE Index of developed countries] is down 49.4%, and emerging markets [measured by the MSCI Emerging Markets Index] by 55.8%.

In recent years, international investing has had a higher correlation with the U.S. market than was traditional. If you invest internationally, you have to invest in foreign companies not as diversifiers but wealth producers. If you like international, get in gradually, maybe with 20% of your portfolio, half in developing markets and half in emerging markets. Europe looks a lot like us, so it's at least possible you might get a better return out of emerging markets. I don't invest internationally myself.

Zvi Bodie: I want to add something that strengthens your case. In markets like China, retail investors can invest only in the tiny fraction of equity investments traded on a stock exchange. So compared with the equity investments there that aren't traded on the exchange, those investments are way overpriced. A much better way to invest is to buy U.S. companies doing direct foreign investment in China.

I distinguish between diversification and hedging or insuring. When I use the term diversification, I use it in the sense that you have a bunch of risky assets, and instead of putting your money in one of them, you spread it across them by paying attention to whether those assets move in lockstep. Because if two risky assets are perfectly correlated, you're kidding yourself if you think you're diversifying.

And then there is insuring or hedging. That's when you've got a safe asset and to my mind that is Treasury Inflation-Protected Securities, or TIPS. One way to protect yourself is to combine a diversified portfolio of risky assets with the safe asset. We teach students that you only need two mutual funds—the risky assets and the safe asset—to generate the entire set of risk-and-reward trade-offs.

Bogle: Amen.

Bodie: And that could be provided at minimal cost. But then a lot of smart people working on Wall Street would be deprived of their high income. So they put all sorts of bells and whistles on these things, none of which has to do with improving the welfare of clients.

Bogle: If people would look at not just a percentage point in costs, but what 1% to 2% in lower returns costs you over a lifetime.

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