The old adage, “Don’t put all of your eggs in one basket,” is a profound guide for investors, too. The way it translates to investing is simple. Diversification solves the problem of unforeseen circumstances negatively impacting your entire portfolio. Investors that know how to diversify the right way are able to avoid their entire portfolio becoming derailed when the price of one stock drops. Unfortunately, many investors do not know the correct way to diversity.
Even the most intelligent financial minds have missed some of the stock market’s biggest surprise blunders, so learning the right way to diversify by buying multiple stocks and creating variance across different industry sectors of the market, geographic regions and market capitalization size, can reduce what is known as unsystematic risk, or risk that can be diversified against. (For more, see: Introduction to Investment Diversification.)
This basic principle of investing is often easy for investors to understand, yet when trying to execute proper implementation, they fall short. Here are some ways investors think they are diversifying their portfolio, but instead are causing increased overlap and decreased diversification.
Choosing Multiple Funds With Similar Strategies
At first glance, what’s wrong with picking multiple mutual funds? If done properly, absolutely nothing. A mutual fund is a bundle of thousands of stocks and can provide increased benefits of diversification for investors in exchange for annual internal expense fees. Some mutual funds represent certain asset classes only (i.e. large cap, small cap, emerging markets, etc.) and have more strict guidelines on what the fund can invest in. This causes the fund to stay true to the nature of the fund at all times.
This is important for investors who are trying to maintain a consistent allocation strategy and helps ensure that there is no style drift or allocation drift due to changes made within the fund. With these funds, what you see is what you get, and you don’t expect for the fund management team to significantly increase the level of cash in the fund or shift to a different asset class to produce greater returns.
Other mutual funds utilize a balanced or general allocation approach, meaning there is much greater flexibility within the fund to invest in large-cap stocks, small-cap stocks, international stocks and even bonds, all in the same fund. These funds aren’t bad for investors, but they do make it more difficult to keep a consistent allocation at any given time. And, what investors will sometimes do is choose multiple funds with this strategy thinking it will result in greater diversification. Choosing multiple funds with similar strategies may not be adding much diversification, but it would be adding more trading costs. (For related reading, see: Diversification: It's All About (Asset) Class.)
Diversifying By Fund Family
Other times, investors may be torn between two funds from different fund families. Both may have decent track records and similar expenses. However, if both funds represent the same asset class (i.e., small cap) then the investor could be overly concentrated in that asset class by investing in both funds. In other words, just because you are invested in two, six or 12 mutual funds, doesn’t mean you are properly diversified.
Diversifying By Advisor
A common strategy utilized by wealthy families is to hire multiple financial advisors to manage portions of the family’s portfolio. The rationale is that by having multiple advisors with different investment philosophies, the result will be proper diversification. This is also not necessarily true. If both advisors utilize individual stock strategies, one may be buying a stock while the other is selling. Each advisor also may not be aware of what the other is investing in, which may cause increased overlap and concentration to certain stocks, sectors of the market or even to cash. While multiple advisors can help increase diversification and bring different investment niches into the mix, it doesn’t necessarily guarantee more diversification.
What True Diversification Means
True diversification is the result of actually focusing on the underlying investments in the portfolio. Those investments should ultimately represent companies of different size, location and industries. When investing in bonds, you can diversify by credit quality, duration and average maturity. The result won’t always mean a higher rate of return.
It’s possible that someone could be too concentrated in large-cap growth stocks and the large-cap growth sector could be the best performing sector. But proper diversification should produce a more consistent investment experience, which is extremely important when you’re planning for retirement and aiming to preserve your life savings.
In summary, despite the many pitfalls of diversification, it can be done. All these methods, when used properly, can lead to increased diversification. But just simply choosing different mutual funds, different fund families, or different advisors won’t guarantee proper diversification. (For more, see: The Importance of Diversification.)
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