What is diversification? How is it obtained? Why does it matter?
In his book Capital Ideas Evolving, the great Peter L. Bernstein put it this way:“The future is always uncertain. Consequently, risk management is fundamental to the whole process. Indeed, risk management is the only part of the process under the control of the investor. Diversification is the most effective form of risk management, and ever decision must be consistent with maintaining a high degree of diversification – or minimal covariance – throughout the portfolio.”
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Now let’s examine three symptoms of a poorly diversified investment portfolio.
Under-DiversificationInvestment portfolios that lack broad exposure to the five major asset classes – stocks, bonds, commodities, real estate, and cash – are not completely diversified. Remember: Authentic diversification does not purposely exclude major asset classes based upon personal preferences or historical performance data.
Here’s another shocking revelation: The mutual funds or ETFs you own may not necessarily be acceptable proxies for the asset classes where they invest. Why? Because those funds may be concentrated in just a handful of securities rather than the entire group.
Yes, the funds and ETFs you own for your core portfolio should be accurate proxies of the asset classes where they invest. In other words, those funds should aim to replicate the performance of the asset class versus trying to outperform it.
Over-DiversificationLet’s say you own the following three equity mutual funds in your portfolio: PrimeCap Odyssey Aggressive Growth Fund (Nasdaq:POAGX), Nicholas Fund (Nasdaq:NICSX), and the T. Rowe Price Mid Cap Growth Fund (Nasdaq:RPMGX). Are you properly diversified?
Although each fund may have a unique investment strategy, all three funds are investing in the same asset class, midcap stocks (NYSEARCA:MDY). That means owning these three funds in the same portfolio would produce unnecessary duplication or over-diversification.
The above example might be extreme, but it’s not a far-stretch from how many people actually invest. I recently did a Portfolio Report Card for a couple with a $405,000 advisor managed brokerage account that held five actively managed high yield munibond funds! Shame on that advisor. It makes zero financial sense to be over-diversified in the same types of investments.
Uneven DiversificationAt times, an investment portfolio will simultaneously suffer from both under and over-diversification. I came across this in a portfolio I analyzed where the investor owned 9 large cap mutual funds (over-diversification) yet lacked portfolio exposure to commodities and real estate (NYSEARCA:VNQI). What is this called? I refer to this condition as “uneven diversification” and it can add unwanted portfolio risk and underperformance.
Among the three symptoms described above, under-diversification is the most common based upon my experience with analyzing and grading more than $50 million in investment portfolios.
It’s true that a properly diversified portfolio won’t completely eliminate market risk. However, spreading your money across a variety of distinctly different asset classes should help you to control the inevitable uncertainties and risk that will come in the future. In other words, diversification is an easy and affordable way to hedge.
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