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Fun with Diversification

We learn at an early age not to put all our eggs into one basket (although few of us walk around with a basket of eggs). An obvious application of this saying involves investing. We know that sometimes a particular asset class is in favor, while at other times it can get a bit ugly. So it makes sense to expose yourself to a diversified group of asset classes to insure a smoother ride.

The topic of diversification can lead us to many interesting and complex areas, but let's focus on a simple comparison of large cap U.S. stocks (S&P 500) and several foreign stock indices -- broad-based (MSCI EAFE), general emerging markets (MSCI Em Mkts) and the flavor-of-the-month, Brazil, Russia, India, and China (MSCI BRIC).

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The Economy Doesn't Matter

The stock market appears to ebb and flow with the daily news about our fragile economy.  Clearly, the health of our economy greatly affects our lives; yet, counter-intuitively, it has less to do with stock performance than you may think.  "Economic statistics have little if any value in forecasting or modeling stock prices," according to the folks who run the Marketfield mutual fund.

Financial Advisor magazine notes that the recent volatility in the stock market has led some investors to search for economic trends and cycles in an effort to predict how the stock market will perform.  After all, as Morgan Stanley points out, "equities are growth assets, so it seems obvious that equity returns should be linked to GDP [gross domestic product] growth."

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The Pain of Patience

One of the most difficult times in investing is when a rational, long-term, diversified portfolio becomes blindsided by the heart-stopping emotions of a steep market decline.  As you watch the stock market drift ever lower, your primal instinct is to flee the apparent danger (although our pre-historic predecessors feared dinosaurs and not the news on CNBC).  Doing nothing is not particularly satisfying. 

Hopefully, you have planned ahead for just such an occasion.  Any money you need in the next year should be in cash, not subject to the vagaries of the stock market.  The rest of your portfolio should be diversified among various asset classes commensurate with your goals and risk tolerance. 

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Perspective

After an ugly day in the stock market Thursday, a little perspective may be in order.  On March 9, 2009, the Dow Jones Industrial Average (DJIA) closed at 6,548.  Capitalism as we know it seemed to be in utter collapse.  And yet, less than two years later, the DJIA closed out 2010 at 11,578.  Not many people would have made the bet in March 2009 that the DJIA would have recovered so rapidly.

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The Debt Ceiling Debacle: A Manufactured Crisis

In The New Yorker this week, James Surowiecki makes a cogent argument that any problems that may arise from the failure of Congress to raise the debt ceiling limit would be a self-inflicted wound.

Surowiecki maintains that the debt ceiling is superfluous because "if Congress really wants to hold down government debt, it already has a way to do so that doesn't risk economic chaos – namely, the annual budget process. The only reason we need to lift the debt ceiling, after all, is to pay for spending that Congress has already authorized."  

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