What Is Diworsification?

Diworsification is the process of adding investments to a portfolio in such a way that the risk-return tradeoff is worsened. Diworsification occurs from investing in too many assets with similar correlations that add unnecessary risk to a portfolio without the benefit of higher returns.

Key Takeaways

  • Diworsification is the process of adding investments to a portfolio to the point that it weakens the risk-return tradeoff.
  • Diworsification is contrary to modern portfolio theory, which helps investors to define an optimal allocation of individual securities across a portfolio.
  • Some factors of diworsification include impulse investing, style drift and generally favoring a particular sector.
  • Financial advisors, robo advisors, and managed funds are strategies used for limiting diworsification.

Understanding Diworsification

Diworsification is a play on the word diversification. A diversification strategy involves an accumulation of assets with varying correlations, which reduces risk and can increase potential returns by minimizing the negative effect of any one asset on portfolio performance.

Diworsification is a concept that is inverse to modern portfolio theory, which helps investors to define an optimal allocation of individual securities across a portfolio, giving investors the best possible return level for the risk that they take on. Modern portfolio theory, however, requires substantial resources, data access, and monitoring, which is not always readily available for individual investment portfolios, where diworsification occurs the most.

Diworsification can occur in a number of ways. Some factors include impulse investing, style drift and generally favoring a particular sector. With impulse investing and sector overweighting, investors overweight their portfolios based on impulse investing tips or high expectations for a specific sector.

Modern Portfolio Theory

Institutional investors have the broadest access to modern portfolio theory technology that can offer the exact proportions of investment in a portfolio of individual securities for comprehensive optimization and diversification. These models can be built from an efficient frontier of investments that can include any security in the world.

These allocations are derived from the basic concept of modern portfolio theory, which seeks to offer investors optimal ratios of balanced portfolios from a capital market line that is drawn to intercept with an investor’s technologically charted efficient frontier.

In personal investing, detailed modern portfolio theory mapping technology is nearly inexistent, leaving investors with only resources for targeted allocations based on asset classes. As a result, serious personal investors seeking to ensure they are building optimized portfolios through their investment decisions will turn to several solutions.

Solutions for Diworsification

Many advisory platforms and market resources across the industry provide support for mitigating portfolio diworsification.

Financial Advisors

Financial advisors are a leading solution for investors seeking to build optimized portfolios and integrate new investments into their portfolios. Many financial advisory platforms have optimized portfolio allocation technology that can provide investors with guidance on their overall asset allocation balance and the weight of each security purchase in their portfolio.

Financial advisors also offer rebalancing services that help investors to mitigate drift from high-performing areas of their portfolio. With a professionally advised portfolio, investors can integrate investment securities across the investment universe.

Robo Advisors and Wrap Accounts

The emergence of robo advisors has added new options for more traditional managed wrap accounts. Similar to mutual fund wrap accounts, robo advisors recommend managed funds based on an individual’s overall risk profile. Robo advisors and wrap accounts build their suggested portfolio allocation percentages based on modern portfolio theory and use advanced technology to advise investors.

Comprehensive wrap accounts and robo advisors especially are limited in the securities they choose to include in their efficient frontier, however. For robo advisors, this limits their optimized portfolio allocation to approximately 10 exchange-traded funds from investment management firms where they have exclusive partnerships.

Suggested Asset Allocations

While individual investors don’t typically have the luxury of working with sophisticated modern portfolio theory technology, they can turn to suggested allocations that have proved successful throughout history. These allocations divide investors into three categories: conservative, moderate and aggressive.

Theoretically, conservative investors will invest lower on the hypothetical capital market line with allocations almost fully weighted to low risk, lower return securities such as money market funds, loan funds, and bond funds. Moderate investors will have a more balanced portfolio of approximately 50% stocks and higher risk securities and 50% lower risk fixed income securities. Aggressive investors will be skewed more toward equities with allocations of up to 90% in equities and aggressive growth securities.

These allocations provide investors with a guide for managing the allocations to asset groups within their portfolios, but still leave them open to broad investment options that can result in diworsification by category. Serious investors will typically choose to invest in managed fund portfolios with allocations targeted for each asset group in order to best mitigate diworsification effects. In some cases, investors may also want to watch closely the correlation of new investments they add to their portfolios.

For example, a newly identified aggressive growth security may seem like a good investment, but when it is compared to the correlation of other aggressive growth securities in the portfolio, it may not offer any overall return advantages. Therefore, investors should not only consider a new investment’s growth potential when adding it to a portfolio, but also the correlation its returns have with other portfolio securities.

Managed Funds

Due to the effects of diworsification, many investors may turn to managed funds for the core holdings in their portfolios. This approach requires a fund manager that adheres to the strategy sought by the individual investor.

Target-date retirement funds offer one of the best examples of managed funds investors rely on for nearly all of their savings for retirement. These funds have allocations that shift over time while also managing for optimal diversification, providing the best potential return while still managing for risk up to a targeted utilization date.

In addition to target-date funds, other strategies exist in the managed funds lifestyle category that can serve as core holdings for investors seeking to mitigate diworsification effects from broad portfolios.

These funds provide investors with a portfolio based on their risk tolerance, ranging from conservative to moderate to aggressive. Vanguard’s LifeStrategy funds are among the most popular lifestyle fund options to help support an investor in managing appropriate diversification.

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