After reading books about investment planning for over five years, I've come to the point where my eyes glaze over when I pick up yet another book. Every hardback and paperback seems to say the same thing and in the same way. But I was handed a book the other day that actually excited me. The reason for my ongoing enthusiasm about this publication is that the authors simplified some seemingly complicated investment principles.*

The topic that excited me the most (so far) is the diversification information located in chapter four. I'll boil it down here to show the authors' rationales for: 1) The importance of diversification; 2) an example of why diversification is important, and; 3) an example of how to diversify based upon what is called an "Investment Risk Pyramid."

First, diversification is the practice of selecting a mix of asset classes and the right investment vehicles within each asset class. The reasons why investors should diversify include the following:

1. To achieve higher after-tax returns consistent with asset growth and income needs
2. To acquire the right balance of liquidity
3. To better match the investments with one's risk-taking propensity and temperament

"Asset classes" represent:

One simple example shows how you can invest without fear, as long as diversification remains a focus: Say that you had $100,000 to invest, and you put that total amount into an investment that offered an 8 percent return rate. After 25 years, that investment would grow to about $684,847. While you might think that this is a hefty return, look at the following results that could be achieved after dividing that $100,000 into five different areas:

Even if you burned and buried two-fifths of that $100,000, this set of five different investments will return a total of $942,800 - a 37.7 percent increase over the amount produced by placing all the money in one investment at 8 percent.

My problem in the past was that I understood all the above information, but I never knew what percentage of my income I should allocate to any given asset class. This book offers one answer to that question with the "Investment Risk Pyramid." This pyramid - similar to the food pyramid - explains where and how invest if a person wants some peace of mind.

The bottom of that pyramid - the foundation, if you will - consists of a mix between the cash equivalents and fixed-income investments mentioned previously. Checking accounts (try to find one that returns some interest), money market funds, CDs, and even gold, silver coins, and some bonds help to build this base. These choices significantly reduce financial risks because they are securities where principal and interest are either ensured or guaranteed. The only risk here is that inflation will mitigate any interest raised by these foundation funds. However, the upper levels are meant to eliminate this loss (which is why investing is so important).

The second level includes "controlled" or "professionally managed" investments like stock funds. These funds tend to return a higher rate than foundation investments, but they're exposed to market and interest rate fluctuations. This is why these investments aren't that liquid - it's not wise to sell an investment based on market fluctuations when the market is down.

Two investments that represent stock funds at BUYandHOLD are the closed-end bond fund and the opportunity to purchase Index Shares. A closed-end fund acts a little like a stock, and a little like a mutual fund, so it fits the bill as an investment choice at this level. With Index Shares, you can conveniently own, buy and/or sell the entire portfolio of various indexes that represent different markets, market sectors or specific industry sectors.

The third level includes aggressive investments such as small-cap stocks. These assets are exposed to the same risks as investments within the second level, but they tend to bring higher returns when growth is realized. While BUYandHOLD carries more mid- to large-cap stocks, the choices that BUYandHOLD offers can help the timid or conservative investor to begin to test the waters in the third level, especially with long-term investing in mind.

Finally, the fourth level consists of what the authors call a "special situations" category. The possibilities at this level include stock options, commodity futures, and limited partnerships. This last level is only appropriate for those who have solid investments built in the previous three levels and who have minimized risks elsewhere as well.

I may never invest in that last level, as I may never acquire the time, money, or courage to brave that type of risk. But, my belief that a solid foundation is vital to build before taking on investment risk has been validated. Alternately, since I have more money invested in the third level than I do in the second level, I now see that it makes sense to focus more on the second level this next year.

This is one time when the adage, "two steps forward and one step back" might build financial security and confidence rather than insecurity and self-doubt.

Until Next Week,
Linda Goin

* Richard L. Randall and Scot W. Overdorf with Michael J. Chapman wrote the book, Ways & Means: Maximize The Value of Your Retirement Savings. Randall and Overdorf are practicing attorneys and Chapman is a financial advisor, and all three men focus on retirement and estate planning. Unfortunately, the book was published in 1999, so it's only available through online bookstores. I found more online venues that carried the book when I typed the authors' names into a search engine than when I typed in the title.

The securities markets are subject to the risks of fluctuating prices and the uncertainty of rates of return and yields inherent in investing and past performance is no guarantee of future results. Savings accounts and certificates of deposit are insured and CD's offer a fixed rate of return.