So You Think You’re Diversified? : The Importance of Asset Allocation and Diversification
One of the first things investors learn when getting started is that they should make sure their portfolio is diversified. Popular wisdom says ensuring that your money is spread out over a variety of different sectors helps protect against losses. Most investors take this advice to heart and make decisions accordingly.
But what if you’re investments aren’t as diversified as you think they are?
Diversification Mistake #1: The Notion that Different Custodians Mean Diversification
Many people think that just because they have money in several different investment accounts with different advisors overseeing them that they are automatically well diversified. And it’s easy to see why investors might make that mistake. After all, it does seem to follow that different investment companies and different advisors would choose different types of investments.
Unfortunately, this isn’t always true. Say you have two advisors and each of them has half of your money. Because they don’t communicate with each other, as most advisors don’t in this situation, it’s possible that they have both independently invested your money more heavily in the same area. Maybe you communicated at one point your optimism for tech stocks and they acted accordingly? Or perhaps they both picked the same ETF when you asked to up your exposure to foreign markets? Suddenly, the little bit of exposure you were going for has doubled into dangerous territory.
Needless to say, having money with two different custodians and two different advisors could possibly lead to less diversification not more.
Diversification Mistake #2: Assuming All Funds Are Different
Some investors spend inordinate amounts of time picking out a portfolio of mutual funds. They believe that having a collection of mutual funds, which they know are made up of thousands of stocks, is a sure bet when it comes to diversification. But what happens if all of those funds are invested in similar positions? Or have the same overall strategy?
Say you have a portfolio of five different mutual funds. All of them utilize what’s called a general allocation approach. This means that the funds themselves aren’t tied to one asset class like large cap, small cap etc. Instead, they are designed to be flexible and may have an assortment of asset classes in them. Now say there was a blip in the market as a whole and all five of your fund companies decided to shift into a large cash position.
Well guess what, you’re now holding a lot of cash and your portfolio on a whole is less diverse and more conservative than it should be given your goals and tolerance for risk.
Diversification Mistake #3: Dumping It All For the Next Best Thing
Of course, it is possible to do everything right when it comes to diversification and then throw all your hard work out the window when something shiny comes along.
The lure of a financial buzz word is a powerful force. Far too many otherwise smart investors have deviated from their well maintained diversification strategies because of it. It is hard not to pull money out of your carefully crafted allocation and invest it in things that seem poised to take off. And it is true that you might make a good profit.
But what if you were to pull all of your money out of cash to invest in a hot small cap stock and then the markets tanked because of an unforeseen event in the news? And what if the crash happened to affect small cap stocks in particular?
So How do I know I’m Diversified?
To be diversified, you have to understand correlation.
Correlation is simply a statistic that measure the degree to which two securities move in relation to each other. Correlation is measured from -1 to +1. Things that are “perfectly correlated” have a correlation of one. They move in lockstep.
So if investment A goes up 5% and investment B goes up 5%, they have a correlation of one. Likewise, if investment A goes down 10% when investment B goes down 10%, they are also perfectly correlated.
Therefore, for effective diversification it’s important to understand how the investments in your portfolio work together. The goal is to try to find assets that don’t always move in the same direction at the same time.
Why? Because effective diversification tends to smooth returns which can lead to more consistent returns and better outcomes for retirees.
Correlations Are Not Static
Twenty plus years ago the foreign stock markets had a lesser correlation to US markets, and therefore adding international stocks was often an effective diversification tool.
International stock that once had a .3 correlation to US stock now could have a .9 correlation! And it makes sense. Given that the world is more interconnected than it was even twenty years ago, these markets more closely mirror each other.
So you can the challenge. This is why investors and investment professionals are seeking out new asset classes to improve diversification. And why newer vehicles are offering exposure to real estate, emerging market bonds, master limited partnerships, and commodities. All with the goal of reducing risk and a producing more consistent results for investors.
So How Can You Tell if Your Assets Are Not Diversified?
When I show clients returns of their different investments over time, they’re sometimes disappointed because while most investments “went up” the question arises “why didn’t they all go up?”
My answer is if all of your investments are going up the same amount at the same time, that’s probably a pretty good indicator that you don’t have an effective diversification strategy! In fact, you may have a concentrated and not diversified portfolio.
But Wait. Can’t I Make More With a Concentrated Portfolio as Compared to a Diversified One?
Yes, it’s possible! It’s possible that if you have a heavy concentration in the right stock, and that stock does well, that you could hit it big and make more money than you could by being diversified.
It’s also possible that you could also lose big! Just ask the employees of Enron or United Airlines that held big positions in the companies they worked for.
Yes, United reorganized after bankruptcy and has come back strong, but did so at the expense of their old shareholders whose stock became worthless. United reorganized, issued new stock, and the old shareholders got pennies on a dollar.
If the goal is to not to hit it big, but to keep up with inflation, earn reasonable returns, and not run out of money in retirement, then a diversified portfolio is the way to go.
Do You Need a Diversification Check Up?
The thing about diversification is that you have to keep revisiting it. It’s not a set it and forget it kind of thing. It’s a check it and check it again kind of thing.
Call your financial planner or advisor. Ask to see an allocation breakdown of your account. If you have accounts at multiple places consider consolidating them or sharing information between advisors so that you can get a big picture view of your portfolio as a whole. Take a look at your mutual funds and make sure you understand how allocation drift could impact them. And don’t dump your allocation strategy just because something new and shiny comes along.
True Diversification is Not Glamorous
Properly diversifying your portfolio can be tedious, but the potential for mistakes is not to be trifled with. Do the slow, plodding work of making sure you understand exactly how your money is invested.
Your retirement account will thank you for it.
The Importance of Asset Allocation and Diversification
It’s hard to stress the importance of asset allocation and diversification enough.
If you’re having doubts about diversification, it might be time to have a talk with your financial planner or advisor. If you don’t have a financial planner, consider finding one in your area who understands how to help you properly diversify your portfolio.
Certified Financial Planner David Wilson, author of this blog and financial planner at Vector Financial Solutions, serves the San Diego area including Escondido, San Marcos, Poway, Rancho Bernardo, and 4S ranch.
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David Wilson, writer at Financial Truths, is a Certified Financial Planner® and Accredited Investment Fiduciary Analyst® at Vector Financial Solutions, Inc. Vector Financial Solutions is located at 139 E. 3rd Ave., Escondido, CA 92025 and by phone at 760-741-3159.