For starters, let’s provide a quick definition of diversification:
Diversification (n.): (1): the process of making diverse; giving variety to (2): to divide funds with the expectation that the positive performance of some will offset negative performance of others (as in investing).
Diversification can be compared to a kitchen sink casserole; it takes time, requires a handful of ingredients and if not executed well, it can result in an experience that is hard to stomach. Just as we believe in making use of food that may spoil, I also believe in diversification. However, there are a few issues that investors should consider when developing a diversification strategy.
1. Why Should I Diversify?
The goal of diversification is to reduce risk. The logic is quite simple. If you invest in things that do not move in the same direction, at the same time or at the same pace, then you will reduce your chances of losing all of your money at the same time or at the same pace. For example, in 2008 the S&P 500 had a negative return of 37.00%, which, on a $100k investment would have resulted in an ending value of $63k. Alternatively, if you had allocated just half of your funds to the Barclay’s Aggregate Bond Index, again for example, your ending value at the end of 2008 would have been approximately $84,120.
2. How Do I Diversify?
Diversification is more than holding different types of investments like stocks and bonds. It is also important to diversify within your stocks and bonds. Within your stock piece, it is important to allocate to companies within different sectors of the market (i.e., technology and healthcare). It is also important to diversify among size of companies in terms of their representation in the overall market. This is referred to as market capitalization ([# of shares in the market x stock price] = market capitalization). Within your bond piece, it is important to diversify among different types of bonds (i.e., government bonds, corporate bonds and high yield bonds). Different types of bonds respond differently to a change in interest rates so spreading funds among various types can help reduce interest rate risk as well as default risk (risk that the corporation, for example, goes out of business and cannot pay interest or return principal).
As you might suspect, diversification can be challenging because it requires an investor to make an informed investment decision on a number of investments. Those that do not believe they have the time, knowledge or desire to do the research required of diversification may elect to diversify by using mutual funds or ETFs. Through these vehicles, investors can delegate the research and selection process to the fund manager who pools your funds with other shareholders to buy a large number of investments.
3. Do I Need to Diversify Across Firms?
Clients will often explain to me that the reason they have so many accounts spread across different companies is to diversify. This may have been necessary 30 years ago, but today you can buy the same stocks and ETFs through TD Ameritrade that you can through Charles Schwab. Most large brokerage firms have selling agreements with the major mutual fund companies to offer their funds as well (i.e. Vanguard, American Funds, Fidelity). Diversifying across firms makes it increasingly difficult to manage your investments effectively. Putting together a clear picture of your portfolio and gauging performance will take a lot of manual work and tedious calculations from your statements.
4. How Can Diversification Go Wrong?
Diversification can go wrong on either extreme, too little or too much. A portfolio invested in 100% stocks, even if spread among a number of diverse stocks is too little because of the lack of other investment types like bonds. Similarly, a portfolio of 5 stocks weighted equally at 20% is too little. Opinions vary on the amount of exposure (percentage) that should be allocated to a particular investment. We generally believe that any more than 5% in one investment is considered concentrated; however if you are using multiple strategies managed by independent managers, then as much as 9% in an investment can be considered conviction versus concentration.
Warren Buffet once said, “Wide diversification is only required when investors do not understand what they are doing.” There is such a thing as “over-diversification”. When adding additional investments to a portfolio, each additional investment lowers risk but remember, lower risk = lower return. Over-diversification occurs when an additional investment lowers the potential return more than it offsets the potential risk. Over-diversification can also be sectional in nature. Sectional over-diversification occurs when there are a large number investments in a particular industry and the behavior of the investments is quite similar. Take for example Pepsi and Coke. The companies are similar in a number of ways so rather than buy both, we would recommend buying the company that presents the best value.
Over-diversification is not only time consuming and inefficient, trading commissions on a large number of investments can be quite costly which may ultimately reduce your overall return.
5. Diversification Tips
- Make a Decision: If you don’t have significant amounts of time, knowledge or desire to complete the due diligence required of proper diversification, consider delegating to a manager whether it be a mutual fund or separate account with individual stocks and bonds purchased on your behalf.
- Get to Know Your Funds: The challenge of diversifying through funds is that the actual investments are wrapped up in the fund name. Although the name may allude to the types of investments (i.e., stocks, bonds, both) and/or their style of investing (i.e., growth or value) you won’t know what they are actually buying unless you look. Quarterly holdings reports are provided for all mutual funds and ETFs. Compare the holdings in your mutual funds to make sure that you aren’t buying funds that essentially do the same thing.
- Set Limits: If you choose to go it alone, don’t overextend yourself. The brightest minds in the industry will not profess to know all 500 companies in the S&P 500 and neither will you. We suggest that you limit the number of stocks you purchase to between 20-40 with no more than 4-5 within each sector of the market and no more than 5% of your total portfolio invested in one stock. It is probably a good idea to keep your bond purchases within the 5% range as well.
- Consolidate: If you have accounts spread over multiple brokerage firms, think about consolidating. Work with your chosen advisor to determine what steps need to be taken and if there are any exceptions to transferability. If you don’t have an advisor that will sort through the specifics of accounts with you, consider finding one that will. We cannot stress this enough for investors at or nearing retirement.
Disclaimer: This has been provided for informational purposes only and should not be considered as investment advice or as a recommendation. Beacon Pointe does not endorse and is not responsible for the content, product, or services of other third party sites or references.