If housing boom ends, diversification is the key

If the easy-money days are over in the U.S. housing market and most of your net worth tied up in real estate, that means it's time to diversify and find appreciation in unfamiliar places.

There are plenty of signs that the U.S. real-estate market may be shifting into slow gear.

With the mortgage market still feeling the pinch of 13 straight Federal Reserve short-term interest-rate increases, few economists are calling for more record-breaking home sales or price increases.

If you can't depend upon home equity as a bulletproof wealth builder, what other opportunities are there?

Home may be where the heart is, but some foreign stocks might yield robust appreciation. While not offering many household names, international small-company stocks are worth considering.

The Vanguard International Explorer Fund (VINEX), which rose 21 percent last year, and the DFA International Small Company fund (DFISX — available only through advisers), was up 22 percent last year. Both funds give you exposure to non-U.S. companies with less than $2.5 billion in market capitalization.

Another category often obscured by brand-name stocks are U.S. mid-cap stocks, stuck somewhere between blue chips and their smaller cousins in terms of size.

Mid-caps had a stellar year in 2005. A good proxy for midsized companies is the Vanguard Mid-Cap Vipers (VO), an exchange-traded fund that rose 14 percent last year, besting the Standard & Poor's 500 Index of the largest U.S. stocks by more than 10 percentage points.

No predictions

Don't get too excited about foreign small firms and U.S. mid-caps. It's hard to say if these stocks will still be burning up the track in 2006.

It's always hazardous to pitch an investment a year after it soars. It may fall flat and it is impossible to consistently predict trends.

The only sure thing in the psychology of investing is that we tend to emotionally latch onto prized stocks and funds and buy high and sell low or just hold on for dear life. Yet lesser-known investments will often shine while our favorites wilt.

A good example of a less-familiar and certainly unsexy investment is real-estate investment trusts, publicly traded companies that own commercial real estate. Few individual investors have REITs as a staple in their holdings and they've been missing out on some healthy returns.

The CGM Realty fund (CGMRX), a mutual fund that owns real-estate stocks and REITs, for example, rose 27 percent last year and averaged almost 30 percent annually over the past five years, beating all but 1 percent of its peers. An even more diversified REIT fund is the Vanguard REIT Index (VGSIX), which samples a good cross section of the market and climbed about 12 percent in 2005.

Familiarity with investments also breeds overconfidence. After a few years of 12 percent returns in the U.S. housing market — that was the year-over-year average through the third quarter of last year — many mistakenly think it's a guaranteed return. Trends don't last, though, and they are certainly reversible.

Remember the period from 1995-1998? Large-company growth stocks dominated, as represented by the Standard & Poor's Barra Growth Index. Blue chips were the top-performing investments during that time, with annual returns ranging from 24 percent (1996) to 42 percent (1998).

Then the tech-telecom bubble burst in 2000 and large stocks hit the skids. In their heyday, the frothiest tech darlings — small-company growth stocks as measured by the Russell 2000 Growth Index — led the pack in 1999 (up 64 percent).

The following year was a different story as bargain-priced small-cap "value" companies (21 percent) took the lead and held it into 2001 (14 percent). A broad portfolio of bonds bested all comers in 2002 (9 percent). Small-growth companies roared back in 2003 (45 percent), then were overtaken by small value stocks in 2004 (21 percent).

Notice the merry-go-round? It's awfully difficult to pick tomorrow's winners based on yesterday's champs. They rotate in and out of favor. Diversification through broad index or exchange-traded funds is one of the only ways of capturing growth without having to guess the next hot spot.

Here's another way of looking at diversification: You nearly always have a winner.

When blue chips bit the dust in their 2000-2002 bear market, bonds, small caps and REITs were all in positive territory.

Another virtue of diversification is that if you've spread your money across all kinds of financial assets and hold them, the winners will compound over time. The annualized return in the Russell 2000 growth index alone was 21 percent (with dividends invested) over the past three years.

Diversification can be liberating because it affords you the luxury of ignoring market forecasts.

And not only will you be able to stop fretting about property values, you can be home free to invest for all of your financial goals.