Long before the days of investment management solutions, financial derivatives and modern portfolio theory, Sancho Panza -- Don Quixote's sidekick – wisely noted, “It is the part of a wise man to keep himself today for tomorrow and not to venture all his eggs in one basket.” Of course, Don didn’t take this sage advice – but you should.
Our clients often ask us how to diversify; while they understand the basic importance of not putting all of those eggs in the same basket, they’re just not sure how to go about it in the most effective manner. Here’s how to avoid diversification pitfalls and create a blueprint to evaluate your own portfolio.
The ‘D’ Word and Financial Strategies
First, the basics: diversification is, at its core, a risk management technique. A diversified investment portfolio balances funds among securities from different industries or different classes, based on the premise that a portfolio of differing investments will, on average, produce better risk-adjusted returns and less volatility than its individual components.
Sounds simple, right? Here’s where it gets a bit complicated.
Concentration is Not an Asset Management Solution
While few would argue against the necessity of diversification to the success of long-term investors, ideas abound – and vary widely -- about what constitutes a diversified portfolio. Further muddying the waters, there’s also an overwhelming amount of misinformation about diversification floating around.
In our investment firm's worldview (which, unfortunately, differs from the mainstream due to the successful and misleading marketing techniques of the financial services industry), diversification means to fundamentally own everything. According to the evidence-based research of Dimensional Fund Advisors, the institutional asset class fund provider to whom our clients’ investment dollars are allocated, a truly diversified portfolio consists of many thousands of individual securities.
We practice what we preach; our client portfolios consist of a global basket of over 9,000 stocks, all but eliminating company-specific and sector risks that have caused -- and continue to cause -- investors so much pain. And if you don’t believe that owning concentrated positions in individual companies is dangerous, simply consider the case of AIG, GM and many of the national, regional, or local bank stocks.
Is Your Investment Professional Misinformed?
But, regardless of our worldview, misleading information about diversification is rampant. Many so-called financial experts, investment professionals and publications simply have it wrong.
Consider the “Am I Diversified” segment on CNBC’s “Mad Money,” where investors call in to have their portfolio diversity evaluated. In most cases, the host gives portfolios with as few as five stocks a passing grade! Such a concentrated portfolio should never be considered diversified -- and promoting the idea that owning a handful of securities is “diversified” is both misinformed and foolish.
In another example, a popular investment education site states that, “a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction.” Really? Currently, investors can purchase low-cost, highly diversified index or asset class funds containing thousands of individual securities. Why would any investor own a concentrated portfolio – and take on larger amounts of risk – when they could own a truly diversified portfolio of stocks at minimal cost?
These types of misinformation are explicitly linked to a lack of investment success.
Why Diversification Matters to Your Comprehensive Financial Plan
Diversification (or the lack thereof) has serious implications for portfolio performance and could even be the deciding factor on whether or not you meet your long-term financial goals. Sound like hyperbole?
Not when you consider that, on average, individual investors significantly under perform as compared to market rates of return. Dalbar’s 2013 Analysis of Investor Behavior found that an average mutual fund investor under performed the S&P 500 by a whopping 48% over a 20 year period ending in 2012.
Brett Arend's column on MoneyWatch.com states it like this: "For example, over the 20 years through the end of 2012, Standard & Poor’s 500-stock index produced an annual return of 8.21% (instead of 4.25% for the Average Investor). So if you’d invested $100,000 20 years ago and then gone away to a desert island, when you returned you’d find you’d get back your original $100,000 investment, plus a profit of $384,000."
Granted, investors’ behavioral biases contribute to their lack of success, but inadequate diversification also plays a key role. Ironically, most investors believe they are well-diversified – because they trust their investment professional's advice – even though most portfolios lack many of the best performing asset classes such as U.S. small cap value, international small cap value, and emerging markets. And even the few portfolios that actually contain these top performers generally contain just a fraction of the available companies.
Over your investing lifetime, diversification -- or lack of it -- may mean up to a six-figure difference in compound returns.
Recommended Investment Managment Solutions and Actions
Given the importance of diversification to your long-term investment success, we recommend that you:
Review your most recent account statement; a list of individual stocks and bonds or a handful of mutual funds indicates that you’re under-diversified
Ask your advisor to explain their beliefs about diversification; if the answer is anything other than owning everything -- i.e. thousands of securities across the global capital market system -- you should be very concerned.
Seek the advice of an independent Registered Investment Advisor (RIA) or CERTIFIED FINANCIAL PLANNER TM regarding diversifying your portfolio.
Work with a RIA that manages assets through indexed portfolios or structured asset class investing.