Diversification: The Risk Factor

The numbers are stunning. The share of the population with a job is at record levels. Homeownership has never been greater. The federal budget is in balance for the first time in three decades. The twenty-year war against inflation is winding down. The stock market is eagerly reaching for new highs. The economy is on a roll.

Yet many people seem to share a sense of unease - with good reason. A U.S. attack against Iraq appears imminent. Corporate layoffs are rising with unexpected force. President Clinton's job is still at risk. The stock market is suspiciously susceptible to violent movements. Asia's financial crisis remains on the cusp of a global economic tragedy. Investors who have watched their money nearly double over the past three years in the stock market can't help but wonder whether its time to bail out.

What is the investor to do? In a word, diversify. The Barron's Finance & Investment Handbook defines diversification as the "spreading of risk by putting assets in several categories of investment - stocks, bonds, money market instruments, and precious metals, for instance." Don Quixote d la Mancha better captured the essence of the idea when he said, "Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket."

However, diversification is a far more powerful and subtle idea than simply creating a margin of safety. We know from our everyday experience of going to work and dealing with our families, from reading the newspaper and history books, that we face many more risks than volatility in the markets. Diversification is a technique, an approach that allows you to embrace the risks you willing to accept and to insure against the risks you'd prefer to minimize. We are all individuals when it comes to diversification.

For example, you're finally going to open your own business--something you've always dreamed of doing. But being an entrepreneur is risky. You'll want to hedge against business failure by building a conservative personal financial cushion. A tenured college professor can easily absorb more investment risk than someone on commission -- even though their earnings may average out to be the same over time. Education should be part of anyone's diversification strategy too. The highest wages are earned by college graduates - and the best insurance policy against a layoff is a good education. For example, the unemployment rate for college graduates in January was 1.9% versus 7.2% for high school dropouts.

The bottom line: diversification pays in more ways than one.


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