Column: Turn risk into your ally through diversification

BY JOSEPH MATTHEWS

Risk, for most investors, is a very scary word, conjuring up images that can easily keep you up at night: Permanent loss of capital. Loss of income when it”™s needed. Shrinking life savings.

We”™ve all envisioned what we believe to be the potential downside risk of a given investment. But then our minds tie the rational decision to prior negative investment experiences, invariably allowing emotion to fog the ability to be rational. Fear gains the upper hand.

With the market behaving like a roller coaster and interest rates near generational lows, many investors are confused about how their portfolios should be structured. Nothing makes this point clearer than the amount of money in short-term investment instruments like certificates of deposit, money markets and savings accounts. The levels of cash earning less than zero percent, after calculating for taxes and inflation (“real return”), is staggering ”” more than $10 trillion based on recent studies. Due to the anxiety, confusion and trauma caused by the bear market and recession, many investors continue to misunderstand the purpose of their portfolios: to fund a future liability.

Is it time to buy? Time to sell? It seems to me that fear has frozen many into inaction.

One of the primary goals of many individual investors is to fund their retirement. The time span between the accumulation and distribution phases for many can be upward of 40, 50 or even 60 years. More often than not, however, the biggest mistake investors make is underestimating the debilitating effect of inflation on the purchasing power of their savings.

By focusing on three things ”” investment time horizon, the need to make withdrawals and one”™s tolerance for risk ”” investors will possess the key factors needed to better construct a portfolio that is consistent with what they are trying to accomplish.

Investors have always been perplexed by the ongoing inability to definitively predict the possible outcomes of portfolio decisions. This anxiety increases with shorter time periods as the likelihood of the market going down in any given year is approximately 20 percent.

Looking at the big picture tells a much different story. The dispersion of market returns ”” as measured by the Standard & Poor”™s index of 500 stocks ”” over the last 87 years shows that the market produced plus 20 percent returns in 34 of those years and minus 20 percent or worse in just 6 of those calendar years with an average gain of 9.9 percent. In spite of this positive skew, many investors remain leery of stocks as a component of their overall investment strategy, remembering, of course, that history is never a guarantee of any future result.

Historically, the use of a well-thought-out asset allocation in building and maintaining a portfolio has allowed investors to experience narrower ranges of investment results. Looking at the time period 1993-2012, a well-diversified portfolio managed to consistently remain in the middle of the pack when compared to nine other investment classes.

As frustrating as this can be in very good markets, like the soaring market in 2013, the potential positive effects on an investor”™s portfolio during poor-to-fair markets can go a long way in helping achieve financial goals.

By the way, the investment class at the very bottom, showing with the lowest returns, was money markets. It managed to be the worst seven times during that 20 year time-frame. This echoes that old axiom: Cash is not a good long-term investment.

Slow and steady not only wins the race, it will help keep many of us in it.

Joseph Matthews is branch manager, first vice president, financial adviser and senior investment management consultant with the Global Wealth Management Division of Morgan Stanley Wealth Management, Fairfield, 203-319-5165 or Joseph.Matthews@morganstanley.com.