You know we advocate diversification as one of the best ways investors can enhance returns and manage risks. We know that asset allocation, a fundamental form of diversification, is the most important decision an investor makes.

Does diversification work? Obviously that depends on your definition of "work." Diversification takes much of the excitement and adrenaline out of investing. Some investors might not like that. But remember, excitement can mean losses as well as profits. And if you diversify a portfolio, you’ll never beat everybody else’s performance.

So why diversify? Because if you do it right, you’ll be more likely to reach your target rate of return. And in the process, you’ll reduce your investment risk. To cite the extreme case, if you invest in only one stock or one mutual fund, your selection is crucial…and a mistake can be disastrous. Diversification also relieves you of the need to "chase" recent high-performing stocks or mutual funds…a strategy that’s more likely to backfire than succeed.

But diversification only works for patient investors who are willing to take a long-term perspective. Can you accept the fact that at the end of the month or the end of the year you will never have the highest performance? When the highest performing sector is something obscure that you’d never invest in anyway, that’s not a problem. But when the hottest sector is something prominent like the Standard & Poor’s 500 Index, it’s tougher to accept a guarantee that you will underperform it.

Here’s something else most investors don’t consider: To diversify properly, you have to be willing to put your money and keep your money in asset classes that seem to stink. Japanese stocks are a current example. Investors who refuse to have any money in the Japanese market may have emotional comfort and "common sense" on their side. But are you willing to bet that Japan’s economic boom is permanently over? History tells us that groups of unpopular markets, like groups of unpopular stocks, are often bargains that will regain their popularity and their prices. When that happens, and we believe it will in the case of Japan, a well diversified portfolio that includes Japanese equities will reap the benefits.

A READER ASKS

We received the following letter from a reader and share it with you to illustrate the complexity of our business:

Our answer:

We are not economists and we don’t try to predict economic events and trends. However, if we had a list of economic worries, an imminent devaluation of the U.S. dollar would be far down the list. If the dollar were devalued, you obviously would want your money in other assets. Two assets you mentioned, gold coins and Swiss francs, are among those we would expect to retain their real value. If you are very concerned about a devaluation, you could invest in such assets, though this is not necessarily what we are recommending.

Perhaps your real question is: How can Americans protect themselves from economic catastrophes that could threaten or wipe out our livelihoods and our savings? Unfortunately, there is no absolutely certain, universal antidote. The troubles we will face in the future may or may not look like the troubles we faced in the past. And the future is sure to throw us at least a few curve balls for which it’s hard to prepare.

One prudent step all investors can take is to diversify outside the United States, by buying mutual funds that own international stocks and/or international bonds. If the U.S. dollar were devalued or suffered a major decline and all other things remained equal, the shares of companies based outside the U.S. would be worth more U.S. dollars (even if each one of those dollars was worth less).

Gold is a traditional hedge against economic bad times. But owning gold didn’t help you during the market crash of 1987 or the slump in 1990. In each case, investors whose portfolios included international stocks and international bonds did better than those with only domestic investments.

In addition, we continue to believe that the best way to protect yourself financially is to stick to some basics. Live within your means. Minimize or eliminate your debt. Put aside some liquid funds for a rainy day. With your investments, have a careful strategy and stick to it like a discipline. Diversify widely, and don’t stray from your comfort zone by taking too much risk. Beyond the strictly financial realm, make sure you are enjoying life. All we have is one day at a time.