What Diversification Really Is (And What It’s Not)

What Diversification Really Is (And What It’s Not)

Over the years I’ve come to realize that diversification can mean different things to different people.  Most financial advisors preach diversification, but I’m often astonished by the allocation strategies that pass for “diversification” in the financial planning industry.  Diversification is the cornerstone of our investment strategy, and we feel that it’s important that you know what we mean when we say that your portfolio is “well diversified.”  Here’s our take on what diversification is, and what it’s not:

Diversification is not:  Five stocks.  Jim Cramer (the host of CNBC’s Mad Money) says that an investor is diversified if he owns 5 stocks so long as the stocks are of various market sectors.  (I’m not kidding.)  He says, “Therefore, 5 – 10 stocks should make a good, diversified portfolio…” I cringe to think of the people who are heeding this advice.  There’s an old saying that all ships rise and fall with the tide; stocks are no different.  Most stocks tend to move in the same direction at the same time.  If the stock market falls, the 5 stocks that you happen to choose are likely to follow suit.  (Source: http://www.stockhomework101.com)

Our take:  It takes more than 5 stocks to diversify a portfolio, period.

Diversification is not:  An S&P 500 index fund.  The Vanguard S&P 500 index fund is by far the largest and most popular mutual fund in the world.  It seeks to follow the performance of the S&P 500 by investing in a collection 500 stocks.   Index investing rose in popularity in the 1990’s as the S&P 500 rose over 18% on average.  Unfortunately, the stocks in the S&P 500 index are all domestic large cap stocks.  Most of the stocks in the index tend to move in tandem and do not provide much diversification.  Investors learned this painful lesson in the market correction of 2008 when the Vanguard 500 index fund lost over 55% of its value (peak to trough).  Investors who thought they were diversified by owning only these 500 stocks were devastated.  (Source:  Morningstar Direct®)

Our take:  An S&P 500 index fund alone does not offer adequate diversification.  It’s a concentrated group of stocks that lacks important components to a well-diversified portfolio.  Index funds can be used as tool to help diversify a portfolio so long as the portfolio includes various markets such as real estate, commodities, alternative investments, stocks & bonds of various sectors and countries, etc…

Diversification is not:  Multiple financial advisors.  Some investors prefer to hire multiple financial advisors to manage different segments of their investment portfolio.  At first glance, this seems to be a great way to diversify an investment strategy.  After all, five financial advisory firms must be better than having only one… right?  If one of the advisors “gets it wrong,” at least you have others who might “get it right.”

Our take:  Having more than one financial advisor is like having two quarterbacks on the football field.  When two or more financial advisors manage a portfolio, the two strategies often clash.  For instance, advisor #1 may decide to buy more emerging market stock in his portfolio.  But the client doesn’t need more exposure to emerging markets because advisor #2 already has emerging market stock in his portfolio.   In this scenario, the client will end up with way too much exposure to a very risky asset class.  This is a classic case of the left hand not knowing what the right hand is doing.  The only way to keep this from happening is to have one firm (your financial quarterback) constantly monitor your overall portfolio.

What is Diversification? Perhaps the founder of modern portfolio theory said it best when he said, “A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.”

Harry Markowitz – Portfolio Selection: Efficient Diversification of Investments, Nobel Laureate in Economics, Professor of Economics at University of California at San Diego

 

-Heath Hightower, CFP®

Heath Hightower

Heath Hightower

As a CERTIFIED FINANCIAL PLANNER™ professional, Heath believes in giving solid, unbiased advice, and building relationships with clients that make a tangible, positive difference in their lives. He helps clients with all aspects of their financial lives, such as retirement planning, education planning, charitable giving, and investing.

Read Heath's Profile HereRead More Articles by Heath