For an investor, managing money is a lot like managing manure for a farmer. Both live by the credo, “spread it around and it will grow.” But as both successful investors and farmers know, you’ve got to know how and where to spread money and manure, or they end up yielding stinky results — or even getting flushed away.
While we can’t help with a manure problem, we do have definite thoughts about spreading money around — in a way that doesn’t cause your portfolio to take a turn for the worse when you try making it more diverse.
Diversification Basics
Anyone can diversify a portfolio. The problem is that it’s deceptively simple — and proper diversification is anything but. Investors typically make three types of diversification mistakes:
1. False diversification. Investors who “falsely” diversify know just enough to be dangerous and act on a vague idea that all eggs shouldn’t go in one basket. So they buy a lot of different stocks, funds or both — with no clue as to how to go about it. Operating under the illusion that they’re diversified, they’re often highly vulnerable. Their decisions tend to result in a portfolio of investments that move in tandem. That is, in a down market, they get clobbered. Except for the high-rolling-conscious non-diversifiers, these investors were the most vulnerable to the market mini-collapse in the early 21st century.
2. Erroneous diversification. Some investors do grasp the concept of diversification, but they don’t realize the mathematical complexity or attention to detail involved in achieving it. They construct a portfolio of relatively uncorrelated investments, but fail to match its risk level to their investment objectives. Typically, these investors fail to include enough high-risk/high-reward areas such as global investments. Or, they fail to include an adequate small percentage of negatively correlated investments that hedge against traditionally turbulent markets — such as precious metals, oil and other commodities.
Erroneous diversifiers also don’t recognize the need for two levels of diversification — first at the asset-class level and then at the investments-within-class level.
Omitting precious metals is an asset-class error, while omitting international stocks is a within-class error. Because less experienced investors tend to limit their universe to stocks and bonds, they’re more likely to be under-diversified in asset classes. In addition, their narrow focus on stocks and bonds might also lead them to the next diversification-error category.
3. Over-diversification. You’ve likely heard the adage: You can have too much of a good thing. So it goes with diversification. At a certain point, the law of diminishing returns takes over when adding new categories and new specific investments to portfolios.
For example, research has shown that a portfolio of about 20 stocks — carefully diversified in terms of company size, business risk, sector and other factors — is about the point at which little improvement can be made. Yet, you might wonder: Why not keep adding if you can still improve by even small amounts?
Here are some reasons:
Commissions. The transaction costs for buying 200 shares in one stock is much lower than what you’ll pay for buying 10 shares each of 20 stocks. As commissions add up, they require better investment performance to overcome them. The same principle often holds true with mutual funds. You’ll generally pay more in transaction costs if you invest $10,000 by putting $1,000 each in 10 funds, versus $2,500 each in 4 funds.
Diluted standards. Unless your income is rising dramatically, the funds you have to invest won’t grow dramatically, so each new investment will seem less significant. Just as the second and subsequent kids in most families get less parental attention than the first one did, you might not be as thorough in later selections as you were starting out. Consequently, those later additions could under-perform and reduce your overall return.
Diverted diversification attention. The more distinct investments you acquire, the more overall work is required to ensure that your portfolio is serving your purposes. For example, perhaps you hold many mutual funds that you’ve thoroughly researched to ensure that they don’t generate excessive capital gains from frequent trading. But without your knowledge, management and philosophy changes could have led to higher trading levels and a bigger capital-gains tax bite — even though you don’t see overall gains that improve your returns. Or, the risk profiles of individual stocks or funds might have changed, and your overall portfolio risk no longer matches your objectives — possibly leading to deteriorated returns from either elevated risk gone bad, or risk-reduced limited returns.
Chapter and Diverse
Although skilled investment diversification is the province of trained financial professionals, almost any investor can make simple strides in correcting errors. The first step is to understand what you’re trying to accomplish, namely: You don’t diversify to increase return. You diversify to construct a portfolio that maximizes your chance of achieving a desired level of return at a risk factor you find acceptable.
With that understanding, review your portfolio with your financial advisor keeping these points in mind:
Different strokes for different folks. The need for diversification depends on individual characteristics such as age, family situation, net worth, risk tolerance and desired lifestyle. Your needs might conflict with conventional wisdom.
Buy and hold. Conventional wisdom can also lead you astray if you have moderate risk tolerance and want to participate in economic growth by buying a single broad-based index fund, such as one that tracks the S&P 500, and holding it long term. You may think your portfolio will grow in step with the Gross Domestic Product, but today’s business climate says otherwise. With small businesses driving much of today’s growth, an index fund invested in established public companies could under-perform the economy. So, it might be wise to diversify into private-equity investments.
Your future’s in the (re)balance. Just as different people should have different types of portfolios, you’re going to be a different person in 10 years. In fact, your situation might change significantly one year from now, so it makes sense to revisit your portfolio at least annually to take into account personal circumstances and investment performance. For simplicity sake, suppose you have five investments you’ve ideally diversified in a portfolio in the following percentages: 35, 25, 18, 12 and 10. One year from now, because of market movement, automatic contributions to certain investments and withdrawals from others, those percentages could easily change to 38, 21, 23, 9 and 9. Meanwhile, the right diversification mix might have shifted to 30, 30, 20, 15 and 5. So, you must re-balance your portfolio to restore optimal diversification.
Assets may be wider than you think. Are you sitting on assets that are excluded when evaluating your portfolio? For example, you might have shares in an employer stock ownership plan, inherited investments, old savings bonds and uncollected family loans. Although you might not turn these over to a trusted financial advisor as part of your investment pot, you should consider them in devising an overall diversification scheme to meet your objectives.
Of course, coming up with a diversification plan to spread out your investments is a time and energy commitment that can leave most investors feeling they’re spread out too thin. This is especially true during down cycles.
Please contact Judith Barnhard via our online contact form for more information.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.
