Diversifying your investment portfolio: It's a dull exercise
that people repeatedly hear, yet a chore they execute with
consistent imprecision. Are there times when diversification can
actually become "Di-Worsification"?
Variety is the Secret
Diversification boils down to spreading your investment risk across
multiple asset classes. It works because of something called
"covariance," which basically means that assets aren't always
perfectly correlated with each other. Let's examine a quick
How to Talk to Your Kids about Money
Commodities, (NYSEARCA:GCC) in one type of market environment,
might rise whereas emerging market stocks (NYSEARCA:VWO)
simultaneously fall. In different market conditions, the opposite
extreme may occur and emerging markets may actually rise whereas
commodities fall. What's the overall effect of owning both
commodities and emerging markets together in the same diversified
investment portfolio? The portfolio's investment returns are
smoothed out. In other words, the poor performance of one asset is
offset by the good performance of another to produce a desirable
Owning Lots of the Same Stuff
Via my Portfolio Report Card service, I recently
graded a $725,000 investment portfolio
that held two mutual funds, two ETFs, and 16 individual stocks. The
owner was convinced that his investments were fully diversified
because two of the funds - the Nasdaq-100 ETF (NasdaqGM:QQQ) and
the Technology Sector SPDR ETF (NYSEARCA:XLK) - each hold a basket
of different stocks.
The problem is that QQQ and XLK are highly correlated (0.97 over
the past decade) in both performance and risk since both ETFs own
many of the same technology stocks. Additionally, the 16 stocks
held in the $725,000 account were more of the same; technology
How can a portfolio with lots of stocks still not be adequately
Remember: Being properly diversified isn't about owning the
highest number or highest quantity of stocks, ETFs, or mutual
funds, but rather owning assets that are different or uncorrelated
from each other.
Avoid Drifting Mutual Funds
Style drift is a major problem facing investors who buy actively
managed mutual funds. This is my second example of when
diversification becomes "di-worsification."
The Fidelity New Millennium fund (Nasdaq:FMILX), for instance,
is categorized as a U.S. stock fund, yet 10% of the fund is
invested in international stocks. When besides never does it make
sense to buy a domestic stock fund to obtain international equity
exposure? In fairness, FMILX is not the only mutual fund labeled
"domestic equity" that invests in foreign securities.
For investors, mutual funds that style drift undermine both
diversification and asset allocation. Think about it this way: If a
person buys 5 mutual funds that each have 10-15% of their fund
portfolios invested in places where the investor doesn't know or
expect, the risk profile of the overall portfolio holding
these 5 mutual funds is radically altered for the worse.
On a positive note for people who build their portfolios with
ETFs, you will never find an index ETF that is labeled "U.S.
stocks" (NYSEARCA:SCHB) investing in foreign securities
(NYSEARCA:EFA) or vice versa.
Investment portfolios that lack diversification are consistently
more volatile and risky than the market. Furthermore, the actual
risk of undiversified portfolios frequently exceeds the risk
capacity of the owners. If these hidden risks aren't pre-identified
and corrected via my Portfolio Report Card or some other mechanism,
investors usually learn about them after they've been clobbered
with deep losses. (See the 60-100% losses experienced by investors
that overweighted their portfolios in bank/financial stocks during
the 2008-09 periods.)
To help people grasp the meaning of true diversification, I like
to illustrate it as the various beef cuts of cattle. (See above)
Each distinct part of the cow isn't necessarily better, but works
together in unison.
Diversification won't prevent market losses. But properly
executed, it should limit risk and reduce your portfolio's
What's wrong with your investment portfolio?
Ron DeLegge's Portfolio Report Card
will tell you. And if your portfolio is smart enough to score an
"A," you'll get $100. It's Ron's way of rewarding well-built
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