By owning many stocks or several mutual funds as well as other investments, such as bonds, commodities, and real estate, you can avoid big losses. How you diversify depends on what kind of risk you're trying to avoid.
The traditional theory of investing – Mr. Markowitz's modern portfolio theory – works to insulate you from the risks of losses in individual stocks by allocating money across different asset classes, such as small companies and large ones, undervalued and fast-growing ones. It doesn't matter so much which stocks or mutual funds you choose. The lion's share of the returns comes from the allocation. All the investor has to do is keep the allocation steady. She does this by periodically taking the gains from winning sectors and putting them into those areas of the portfolio that haven't done so well – in essence, selling high and buying low.
There's plenty of academic research that shows handsome returns over the long term using such a strategy, says Solin, who advocates the approach.
Another approach comes from Benjamin Graham, legendary investor and guru to Warren Buffett and many other so-called value investors. Instead of passively investing in asset classes, they actively try to pick great companies, which can provide big returns no matter what the market is doing.
When the market is in one of its secular bull markets, the passive approach of modern portfolio theory works well, says Mr. Easterling, who advocates the Graham method. But when the market is in one of its secular bear phases, as it is now, investors need to be more active in picking stocks.
How do these approaches compare? Index funds routinely beat actively managed mutual funds, Solin says. Easterling argues that the better comparison is with hedge funds, which typically use more investing tools to achieve gains. From the beginning of 2007, when the market last peaked, through July 2011, all of Solin's portfolios were in the black: up nearly 7 percent for the most aggressive portfolio to 15 percent for the most conservative. Of the hedge funds covered by Hedge Fund Research (not all funds report their results), the average hedge fund was up 19.3 percent during the same period after expenses.
Either way, a system that guides investments can help you keep your cool the next time the market tumbles.
