Portfolio diversification is an investment strategy designed to limit risk by spreading money across multiple asset classes and securities. Most financial literature along with your local financial advisor will agree that diversifying your investments is a prudent thing.
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But while diversification may seem like a straightforward process, it isn’t. And some investors and their advisors have unfortunately misapplied the basic tenets of a properly diversified portfolio. Where have they gone wrong? And what can be done to fix the mistakes?
Let’s examine three portfolio diversification errors.
The most common type of diversification mistakes is “under-diversification.” For instance, an investment portfolio that has 100% of its market exposure to a single stock and nothing else would be one example of an under-diversified portfolio. Even if that stock happens to pay a good dividend, have excellent historical performance, and be very popular – concentrated exposure to just that one company would subject your investments to higher volatility and risk.
Another dimension of under-diversification deals with a lack of market exposure to all the major asset classes. For example, portfolios that miss at least some simultaneous exposure to stocks, bonds, commodities, real estate, and cash are, by definition, under-diversified. In other words, portfolios that deliberately or by ignorance omit major asset classes cannot be accurately defined as “diversified.”
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The easiest way to avoid under-diversification is to make sure the foundation of your portfolio is built upon broadly diversified index ETFs that cover stocks, bonds, commodities, and real estate. Finally, always make sure your portfolio has cash. It will provide you with liquidity, a cushion when market prices fall, and the flexibility to buy assets that are on sale. None of these advantages are given to fully invested portfolios.
The over-diversified portfolio owns too much of the same thing or too much of everything. For example, if an investor owns the Nasdaq 100 (NasdaqGM:QQQ), the Dow Jones Industrial Average (DIA), and the S&P 500 (SPY), they own too much of the same thing because they have over-diversified their market exposure to large company stocks. Although each of these three indices owns different stocks with different weighting schemes, many of the actual companies are duplicated inside all three benchmarks. More importantly, the risk profile and characteristics of the stocks within all three indices are nearly identical, which gives the investor that simultaneously owns all three indices virtually no diversification benefits.
The best way to avoid over-diversification is to not own too many of the same types of stocks, mutual funds, or ETFs inside your portfolio.
The mistake of uneven diversification is the least common diversification error. Nevertheless, I’ve come across it during my Portfolio Report Card analysis. How is uneven diversification different from under and over-diversification?
A portfolio that holds exposure to all the major asset classes – stocks, bonds, commodities, real estate, and cash – may seem like its adequately diversified. However, if the investor is overleveraged or highly concentrated to just one or two of these major asset classes, it would result in an unevenly diversified investment portfolio.
Based upon what I’ve seen, uneven diversification is most common among investment portfolios that haven’t been periodically or routinely rebalanced. For example, a portfolio that might have started out with diversified exposure to stocks that experiences surging equity prices will undoubtedly have higher exposure to stocks thereby triggering the possibility of an unevenly diversified portfolio. To avoid the probably of uneven diversification, make sure you regularly rebalance your investments back to your target or desired asset allocation mix.
As I teach in my online investing classes, having an adequately diversified portfolio is a wise, noble objective. It prevents you from risking your entire nest egg on just one stock or one asset class. It also helps you to have some peace of mind knowing that if one particular area of your investments don’t perform, it won’t nuclear bomb your financial well-being.
In the end, to be properly diversified you’ll need to avoid the three common diversification errors made by many.