Common Investment Diversification Problems and How to Avoid Them
You’re diversified, right? You own all kinds of investments – individual stocks, traditional mutual funds, and those new-fangled exchange-traded funds (ETFs) – and have multiple accounts at different financial institutions. That’s enough, isn’t it?
Well, maybe not.
Many investors believe their portfolio is more diversified than it really is. Here’s a sample portfolio that on the surface might appear diversified:
- Fidelity Blue Chip Growth Fund
- Schwab Dividend Equity Fund
- T. Rowe Price US Large Cap Core Fund
- Yacktman Fund
- Rydex S&P Equal Weight ETF
- iShares 400 Social Index ETF
- Procter & Gamble
Dig a bit into this collection of six funds and four stocks, and you’ll see that this portfolio is not well diversified at all. It’s invested almost exclusively in large-cap U.S. stocks. There’s almost no exposure to small-cap or international stocks, and there’s no bond exposure. A big chunk of your overall portfolio is in the top 25 U.S. companies, and the individual stocks you own are among the largest holdings in several of your mutual fund holdings. Your risk level is comparable to just owning a single S&P 500 Index fund.
This portfolio illustrates some false signs of diversification:
1) Large quantity of mutual funds or ETFs from different fund companies
2) Accounts with different institutions
3) Several different large-company stocks
A truly diversified portfolio includes many different kinds of assets, as well as many different companies or governments within each asset class.
The most basic division of asset classes is between stocks and bonds. Both stocks and bonds can be further divided by geography. Stocks can be categorized based on company size or by whether they are value or growth stocks, while bonds can be categorized based on credit rating quality and whether they are short, intermediate, or long-term bonds. You may also add real estate and commodities for additional diversification.
To build a well-balanced diversified portfolio, follow these steps:
1) Assess how your current portfolio is allocated.
If you have multiple investment accounts, including employer retirement plans, IRAs, and individual accounts, you need to get an aggregate view of your asset allocation. If you’re a Quicken user, you can access its asset allocation report. Many brokerages and banks offer aggregation services that will provide some level of detail on your total holdings.
2) Select what percentage of your portfolio you want to invest in each asset class.
This decision is a function of your risk tolerance, time horizon, and goals. For those with a moderate risk tolerance, I recommend using these general ranges as a starting point:
- Just starting out (20s and 30s): 60% to 70% stock
- Peak Accumulation Years (40s and 50s): 50% to 60% stock
- Nearing / In Retirement (60s+): 40% to 50% stock
You may wish to exclude some asset classes completely if you their risk level is inconsistent with your goals. Make this decision with caution, however, because even an asset that doesn’t seem to fit with your objectives may play an important diversification role in your portfolio.
For example, you might be inclined to opt out of risky-sounding assets like emerging markets, commodities, or global real estate completely. But when you add these investments in small doses, they can increase your projected returns with very little effect on the portfolio’s overall risk because of their lower correlations to the U.S. stock market.
3) Determine what “vehicle” you will use to invest in each asset class
This can be a combination of individual stocks, mutual funds, and ETFs, although building a well-diversified portfolio of individual stocks is tough for many investors. Here are the most important factors in picking an investment vehicle:
- Low cost: Cost is one of the biggest determiners of fund performance, so cheaper is generally better. Costs vary for different asset classes, but low-cost index funds usually come in between 0.10% for large-cap U.S. stocks to around 0.30% for emerging markets funds.
- Specific objective: Knowing what investments a fund can buy lets you control your asset allocation, rather than the fund manager drifting among different types of investments.
- Number of securities in the fund: More is better.
If you’re just getting started, you should look for funds that combine asset classes (still with specific percentage objectives) to help meet fund minimums and keep transaction costs down. This can include target retirement date funds, lifestyle funds, or balanced funds.
After you’ve selected funds in each asset class, you should use the same method you used in step 1 to ensure your portfolio achieves your target percentages and diversification goals. Specifically look for overlap issues between funds.
4) Make your investments, and then monitor your portfolio and rebalance periodically (no less than once a year).
Following these steps to real diversification puts you in control of the risk level of your portfolio. It can be tempting to fall for the “false signs of diversification,” but by putting a bit more effort into your allocation, you will be better positioned to withstand market downturns and benefit from upswings.
This blog post was also selected for publication on The Motley Fool.