Don’t De-Worse-ify When You Diversify

Posted on Wednesday, August 08, 2018

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.

Other Points to Keep in Mind

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 adviser 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.
Buy and Hold. Conventional wisdom can also lead you astray if you have moderate risk tolerance and want to participate in economic growth by purchasing 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 underperform the economy. So it might be wise to diversify into private-equity investments.
Your Future's in the Balance. Just as different people should have different portfolios, you're going to be a different person in 10 years. So it makes sense to revisit your portfolio at least annually to take into account personal circumstances and investment performance.
You May Have More Assets than You Think. Are you sitting on assets that aren't included when evaluating your portfolio? For example, you might have shares in a company ESOP, inherited investments, savings bonds, and uncollected family loans. While you might not turn these over to a trusted financial adviser as part of your investment pot, they should be considered in devising an overall diversification scheme to meet your objectives.

Diversification Basics 

Anybody can diversify a portfolio. The problem is that it can seem 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 are often highly vulnerable. Their decisions tend to result in a portfolio of investments that move in tandem. So in a down market, they get clobbered.

2.

Erroneous Diversification. Some investors do grasp the concept of diversification, but don't realize the mathematical complexity or attention to detail involved in achieving it. So 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 and miss out on opportunities such as China's economic ascendance. Or, they fail to include an adequate small percentage of negatively correlated investments that hedge against 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 fact, if they have diversification religion, 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 four 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 underperform and reduce your overall return.

Diverted Diversification Attention. The more distinct investments you acquire, the more overall work required to ensure that your portfolio is serving your purposes. For example, perhaps you hold numerous 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. That can lead to deteriorated returns from either elevated risk gone bad, or risk-reduced limited returns.

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.

Posted in Tax Topics For Individuals

Disclaimer: The information contained in Dulin, Ward & DeWald’s blog is provided for general educational purposes only and should not be construed as financial or legal advice on any subject matter. Before taking any action based on this information, we strongly encourage you to consult competent legal, accounting or other professional advice about your specific situation. Questions on blog posts may be submitted to your DWD representative.

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