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Nov. 19, 2010, 12:09 p.m. EST

Three new investing rules to live by

Commentary: It’s a new world order, and investors need to change to survive

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By Robert Powell, MarketWatch

BOSTON (MarketWatch) — It’s a challenging environment in which to make money — volatility is high as evidenced by this week’s stock-market action, and returns are sideways to low — but that doesn’t stop people from trying.

Nor should it, said Andrew Lo, chairman and chief scientific officer of AlphaSimplex Group, finance professor at MIT, and director of the MIT Laboratory for Financial Engineering.

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But before investors proceed, they should consider the new world order of investment truths, specifically the following three principles.

1. The volatility of volatility

“The first truth is the fact that volatility is unstable,” said Lo, whose firm also manages funds for Natixis Funds.

“Any kind of reasonable strategy to boost returns in a low-return environment must take into account the volatility of volatility,” he said. “You must manage risk on an active basis. It’s more important than ever before.”

In other reports, Lo has described the past few years as a volatility roller-coaster ride. Traditional investments are now unpredictable. The S&P 500 historically had volatility of 15%, but it has reached 85% in recent years. In other words, it’s possible to lose all of your money in a few days.

“I don’t think it’s possible that anyone can stand that kind of risk,” Lo said.

2. Diversification is different

The second truth has to do with diversification. In the old days, it was considered prudent to have a portfolio with 60% invested in stocks and 40% in bonds. In the old days, in the simplest of examples, when stocks went up, bonds went down, and when stocks went down, bonds went up. Those asset classes were uncorrelated; that was the chief benefit, and point, of diversification.

Today, however, it’s considered imprudent to have a traditional 60/40 portfolio. Because of the influx of assets into the financial industry, an increasing number of asset classes are correlated and it’s become much more difficult to find unique opportunities.

“Diversification is more difficult than ever before,” Lo said.

Creating a well-diversified portfolio today means allocating your assets across a wide mix of investments — from currencies to commodities to distressed securities; going long as well as short; and doing it all dynamically.

A few funds that fit the bill are, of course, those managed by Lo’s firm, including Natixis ASG Global Alternatives /zigman2/quotes/208839105/realtime GAFAX -0.40% , Natixis ASG Diversifying Strategies , ASG Managed Futures Strategy /zigman2/quotes/200704231/realtime AMFAX -0.31% .

According to Morningstar, two funds that might be considered similar are Gateway /zigman2/quotes/209052117/realtime GATEX -0.10%  and Hussman Strategic Growth /zigman2/quotes/203176466/realtime HSGFX -0.31% .

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