The Bottom Line: Got risk?

<SYNOPSIS> Is there a magic formula to investment portfolio diversification? We'll take a look at the types of returns local investment professionals and seasoned investors could have seen from allocating their assets in everything from rental property to stocks on Wall Street over the past 20 years.

Here's my latest from The Oregonian:

Is there a magic formula to investment portfolio diversification? Some say to subtract your age from 110 to determine what percent of your assets should be inside the stock market. For example, at age 30, 80 percent would be in stocks, but at age 60, only 50 percent. But every theory has its detractors.

"You have to throw all the formulas out the window," says Michael Chrysler, president of Lake Oswego's Chrysler Asset Management. "Everyone wants to try to generalize it to make it easy, but every investor's goals, situations, objectives and tolerance for risk are different."

If pure asset growth is the goal, D.A. Davidson & Co.'s chart of stock market index returns over the past 20 years shows wide variances. Adding annual returns and dividing by 20 years, the standard "small growth" index rose 9.5 percent, "small value" rose 14.1 percent, bonds rose 8 percent, "large growth" rose 12.7 percent, "large value" rose 13.6 percent and foreign stocks rose 11.8 percent.

Granted, some years had huge drops, like the 30.3 percent loss in the Russell 2000 small growth stock index in 2002. Other years had huge gains, like the 69.4 percent jump in the Europe, Australia and Far East stock index in 1986. In 1990, every asset class was in the negative except two: Bonds had 9 percent growth and commodities topped the list at 29.15 percent growth. In the long term, each class evened out to 9.5 percent to 14.5 percent growth per year.

Protecting your assets through diversification outside the stock market is equally important to shield yourself from a market crash.

Thomson Financial reports that real estate grew an average 12 percent annually and commodities grew 13 percent from 1985 to 1994.

"The key is being able to participate in areas that are not directly exposed to each other," says Guidant Financial's Jeremy Ames, a national investment trainer who taught a course on portfolio diversification into real estate in Lake Oswego on May 4.

Wilsonville's Mike Krueger, president of 16-year-old MK Commodities, sees this every day.

"If you own a chunk of stock and 15 percent commodities, then your overall performance is better off over time. If one goes in the kicker, the other gains," he says. "The acceptance of this type of diversification, known as the modern portfolio theory, has just exploded."

So has the number of investment opportunities since this theory got its start in the 1950s.

"In the 1950s, the main asset classes were stocks, bonds and cash, with stocks broken down into large-cap and small-cap - at most four or five asset classes," says Harry Markowitz, creator of the theory, who won the 1990 Nobel Prize in Economics. "Now you have emerging markets, domestic stocks, foreign stocks,  commodities. These are often a lot more speculative, and you can see that in terms of historical volatility."

With those new classes has come additional risk.

"This is definitely a problem we're seeing more and more of," says Chrysler, who sells securities through Lake Oswego's Raymond James Financial Services. "My experience is that a lot of people were over-weighted in technology stocks and got really hurt when the 'hot dots' blew up in 2000."

"Now they're doing everything they can to try to catch up, including chasing more speculative investments," he says. "It's our opinion that - while they're now getting good returns - they really don't understand the level of risk."

He says risky areas include hedge funds, which are largely unregulated, and small-cap stock.

"Small cap companies have always offered good returns when you look at those over time, but they're substantially more risky; since they're smaller they often haven't been around as long or the management's not as proven," Chrysler says. "It's a riskier class; investors may have a portion of their money in small caps, but we think many investors right now probably over-own those stocks."

A Financial Resources Corp. study of national mutual-fund data notes that billions of dollars moved in recent years from conservative mutual funds to domestic small-caps.

"Risk is back in vogue," wrote Jeff Opdyke of the Wall Str eet Journal on April 26. "For small investors, that means now is the time to practice some prudence."

Perhaps prudence is the secret ingredient to that magical formula.

-- Jennifer D. Meacham, "The Bottom Line" business and personal finance columnist, The Oregonian and Gather.com

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