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Seeking Diversification

You can mix together a diversified portfolio of investments.
Putting part of your principal into equities, part into fixed-income investments, and perhaps part into cash is only the first step in creating an investment portfolio. Next, you'll need to decide among individual investments, separate account funds within variable annuities, mutual funds, or exchange traded funds (ETFs) within those asset classes in order to diversify the portfolio. The first step is identifying subclasses of investments within each of the three asset classes. And if you're including other asset classes, you'll want to diversify within them as well.

IF YOUR TIMING IS OFF While the ups and downs of investment performance are clearly recognizable, it's almost impossible to predict when they might occur. If you try to time the market — for example, if you wait to buy until exactly the moment you think an investment is about to take off, you run the risk of being out of the market when the price increases most. And you'll probably end up paying more to own it.

In a simplified example, even though a separate account fund that invests in small-company stock and another one that buys large-company stock are both equity accounts, they are significantly different investments. Each one exposes you to different levels of risk, changes in value at different rates, and may prosper in different economic circumstances. So when small-company stocks are providing stronger returns than large-company stocks, a small-company fund in a separate account is likely to provide a stronger return than a large-company fund in that separate account, and vice versa. If you own each type of separate account in your variable annuity, you're positioned to benefit from a strong return on at least a portion of your portfolio, no matter which account is providing it. The same general principle applies to individual stock and bond investments, to mutual funds, and to ETFs.


Diversification works because, just as the major asset classes tend to move in opposite directions, so do the subclasses within them.

For example, when investors are buying stocks, stocks provide a strong return and bond returns are likely to be weaker. And when investors get out of the stock market and buy bonds, bond returns generally strengthen and stock returns weaken. Similarly, small companies may prosper during a period in the economic cycle when large companies tend to struggle. If you keep money invested in a variety of asset subclasses, you can benefit in two ways. First, you're in a position to profit from strong returns in a particular subclass. Second, those gains can help offset losses in a class or subclass that's slowing down.


If you're seeking diversification in your 401(k) or similar plan, and the plan offers just a few choices in each asset class, making decisions is simpler than it might otherwise be. You can carry out your strategy with the choices you have, and make sure you diversify more broadly elsewhere in your overall portfolio. If you have several choices within a single asset class — say several stock separate account funds — you'll want to look first at each one's investment objective. Try to avoid investment in several funds that are all making the same type of investment. To choose among those that invest in similar ways, you'll want to consider past performance, fees, and a variety of other factors. While a separate account fund's name is often a useful clue to the kind of investment it makes, don't take it at face value. Look first at the prospectus for its official statement, and then check to see if the fund is classified by research companies, including Standard & Poor's, Lipper Inc., and Morningstar. You may find that a separate account fund that describes itself as a small-company account actually has substantial investments in medium- and large-sized companies. That could mean you're not as diversified as you'd like to be, and may need to look at other alternatives.


International investments, especially equities, are also an important part of diversification. Because the world's economies respond primarily to events and conditions in their homelands or regions, investing abroad is a way to build a broad-based portfolio. And the opportunity to invest in emerging as well as developed markets offers a further level of diversification. While international investing provides diversification simply by raising the number of potential investment choices, it also adds diversity by spreading your investments across different regions of the world. For example, putting money into a European fund or an Asian fund can position you to benefit from potential strength in those areas during periods when the US economy is sluggish or in recession or when the value of the dollar is low. In general, variable annuities, mutual funds, and ETFs provide the simplest way to invest internationally, since they handle all of the currency and taxation issues that go along with buying and selling abroad. But you may also consider American Depositary Receipts (ADRs) issued for the US market by companies based abroad. And many US companies realize a substantial portion of their revenue from overseas markets, so they may add an element of international investment to your portfolio.

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