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After the huge losses in markets last year, the long knives have come out on diversification.

It seems that everyone now shuns the idea of owning multiple asset classes. Curiously, no one was complaining in 2002-2007, when bull markets prevailed in just about everything. Of course, the crowd has a habit of promoting (or remaining quiet when it comes to critical comments) about strategies that are working in real time. After the fact, it's all a bunch of hogwash. So be it. That's the nature of finance: History, and what passes for intelligent counsel, is constantly being rewritten to suit the moment.

The latest attack comes from Jim Rogers, celebrated trader and promoter-in-chief of commodities as the solution to what ails investors everywhere. For the record, we like and respect Jim Rogers. He's earned a well-deserved reputation as a trader who's made a fortune in a business where success is rare. His record speaks for itself. But we disagree vehemently with his latest commentary on diversification, which he equates with a cheap trick dreamed up by brokers trying to fleece clients. Here's what he said, verbatim, courtesy of an interview last week with BusinessWeek:

Diversification is something that stock brokers came up with to protect themselves, so they wouldn't get sued [for making bad investment choices for clients]. Henry Ford never diversified, Bill Gates didn't diversify. The way to get rich is to put your eggs in one basket, but watch that basket very carefully. And make sure you have the right basket. You can go broke diversifying. Ask anyone who's diversified in the last three years. They've lost money.

With all due respect, Jim, you're not being fair to diversification, nor does it appear that you fully understand what it is, what it's designed to do, or not do, and what's required of investors who manage a "diversified" portfolio. We'll be diving into these questions and the related lessons in more detail in the next issue of The Beta Investment Report, but here are a few thoughts as a preview.

First, let's define diversification, which can mean different things to different investors. The standard definition relates to diversification within an asset class—owning a broad equity index fund, for instance, vs. one stock. That by itself doesn't mean an investment portfolio's diversified. That higher standard requires owning multiple asset classes, with an emphasis on those that tend to move with some degree of independence. The classic example is a portfolio comprised of stocks and bonds, although there are many more combinations available in the 21st century.

On that note, diversification with stocks and bonds performed quite well last year relative to owning stocks alone. Although equities were crushed last year, a broadly defined fixed-income fund did quite well. One example is the iShares Barclay Aggregate ETF, which posted a 7.9% total return in 2008.

Meanwhile, the asset class that Jim Rogers loves so much—commodities—suffered one of its biggest losses last year, to which we're reminded of the proverb in Luke: Physician, heal thyself. Jim has been promoting commodities in recent years, and for quite a while it was a great call. But not last year. Perhaps owning something more than commodities wasn't misguided after all.

Ultimately, asset classes are neither good nor bad, although their expected returns and risk vary through time. The key lesson: the price of risk means something, all the more so because it keeps changing. That implies that we should pay attention and adjust asset allocation accordingly. In a perfect world, with absolute foresight, we wouldn't need diversification or asset allocation. We'd simply pick the best investment destined to dispense the highest return.

Unfortunately, it doesn't work that way. Sometimes even the smartest investors make mistakes, reminding that we're all fallible. With limited insight into the future, prudent investors will hedge the risk. The breadth and depth of the hedging will vary depending on the individual or institution. Some of us are more risk averse than others.

Meanwhile, some of us are more confident than others about what's coming. Jim Rogers, for instance, is still bullish on commodities, as he explains in the interview noted above. (As a digression: Was he bearish on commodities a year ago?) In any case, let's say you agree that commodities look like a great play on the future. Let's say too that you're wildly bullish on commodities. Are you going to put your entire portfolio into commodities? Or how about putting everything into agricultural commodities? Rogers is apparently quite bullish on the likes of corn, wheat, etc.

We'd recommend otherwise, even if you're the world's smartest commodities bull. Yes, you might want to overweight commodities, perhaps aggressively, relative to the passive weight implied by Mr. Market. But shunning diversification entirely? It's hard to think of a more dangerous piece of advice, especially for the masses. Then again, your editor isn't a highly regarded trader and so maybe we're just uninformed.

Source: In Defense of Diversification