Investors don't know where to turn in the current market craziness, so they are turning to what they know.

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Investors don’t know where to turn in the current market craziness, so they are turning to what they know.

That may make them slightly more comfortable but might not help them ride the storm out.

The issue at the center of the market’s problems starts with risk, namely the lousy credit risks that individuals and lenders took on mortgage deals that common-sense suggested might not have been the best idea.

Lenders, investors, government officials and regulators either encouraged the action or looked the other way, and over time it evolved into a full-blown credit crisis and a deflating housing bubble, which together have thrown the economy and Wall Street for a loop.

It also has pushed investors to action. Studies show that when losses pass the 20 to 25 percent range, even buy-and-hold style investors start to get itchy feet.

The temptation is to control risk by getting rid of it, but that’s wrongheaded thinking because risk is ever present. Sidestep one risk and you put yourself in harm’s way for another.

For example, you can avoid market or principle risk — the potential for your investment to lose ground in the stock market — by selling out of equities and moving it all into money-market funds or bank accounts.

There, however, you run smack dab into purchasing-power risk, which is the chance that your money won’t keep pace with inflation, so that in time it’s almost like you suffered a loss anyway.

Spread money around

That’s the whole point of diversification. Rather than expose a portfolio to one or two types of risk, spread the money around, which should put at least some of your money into investments that are at the top of the cycle. You’re balancing principle risk, purchasing-power risk, credit risk, default risk, currency risk, government and economic risk and more.

And then, to sleep at night, you may decide which risks you are most comfortable with, and which you want to minimize within your portfolio.

“Diversification has never been more important than it is now. But that does not necessarily mean buy and hold, and it does not necessarily include diversifying into financial stocks or other sectors that are damaged,” says James Stack, editor of the Investech newsletter.

“You don’t want to get out of stocks completely, or to avoid large caps or something that is a big part of your portfolio. But you do want to look at sector allocations to make sure the fund is investing in a way that makes sense to you.”

So, for example, an investor might want to avoid a fund that is overweight in financial stocks. The Vanguard Index 500 has about 15 percent of its portfolio in financials, but Janus Twenty has less than 10 percent. By comparison, Legg Mason Value Trust has nearly twice that in financials.

Top of peer group

It’s no surprise, therefore, that the Janus fund is near the top of its peer group over the short and medium terms, while the Legg Mason fund is at the very bottom, according to Lipper. The Janus fund hasn’t been able to outrun the losses experienced by large-cap stocks, but Legg Mason investors have been clobbered; in either case, understanding how the fund works and the strategy it pursues is critical to turning it into a comfort zone.

Finding the asset allocations of your funds is simple as easy as calling the firm, looking in your most recent semiannual report or relying on a service like Morningstar or Lipper, which provide the data online free.

From there, the idea is to find funds that you can be comfortable with now and in the future, rather than simply bailing out of an asset class due to recent pain.

“If you want less small cap, that’s fine; if you have less outside the United States, that’s fine, too,” says Bob Doll, global chief investment officer for equities at BlackRock. “But don’t ignore asset classes that have been hit hard and don’t take a position where you have had it for a long time, suffered a loss in the last 12 months and run away somewhere from it close to the bottom. … In this environment, you want more diversification, not less.”

Doll warns that there is another phrase for investors who shy away from the market and move exclusively into their comfort zones. It’s called “backing yourself into a corner, and most people do it at just the wrong time. … We’re closer to the bottom than we are to the top, so we’re probably close to the wrong time right now.”

Chuck Jaffe is a senior columnist

at MarketWatch columnist. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.