3 Common Diversification Mistakes

Dear Mr. Market:Diversification 2

Whether you handle your portfolio or hire a professional to manage it, there is no way you have not heard of the importance of diversifying your investments. The reality is, however, most investors fall prey to one of three major diversification mistakes; which of the three is your issue?

First and foremost, let’s briefly review what diversification is:

Investopedia defines Diversification as: ‘A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

At first glance this makes sense and doesn’t appear to be complex, right? We find that investors typically appear to be in one of three different camps when it comes to diversification:

  1. Under Diversification
  2. Improper Diversification
  3. Over Diversification

Let’s take a moment to look at each and how investors can get their portfolios back on track.

Under Diversification

If you ever turn on your television looking for a summary of the day on Wall Street, you might stumble across Jim Cramer’s television show ‘Mad Money’. One of his more popular segments is, “Am I Diversified?”.  Investors will call in with their equity holdings and Cramer provides them with a “boo-yah!!!” some sound effects and his thoughts on their holdings. Cramer has been quoted as saying that a diversified portfolio consists of 5 – 10 individual stocks. For anyone who knows just enough to be dangerous, this is not only comical “advice” but it’s flat out wrong! Even if each stock position is in a different industry and market cap, the risk associated with a portfolio like this is huge. The brightest minds on Wall Street are managing billions of dollars, yet over 80% of the actively managed mutual funds underperform their index or benchmark every year!  If they struggle to beat, or even match the market, how is the average investor expected to do better? To borrow a popular proverb, “Don’t put all your eggs in one basket.”

Most investors we meet initially come to us with portfolios that have far too little in emerging or frontier markets, REIT’s, or alternative investments. The average portfolio is almost always under exposed to International investments as well since most of us suffer from familiarity bias.

Improper Diversification 

Individuals will often have a concentrated position with their employers stock or in a company that has been posting impressive results (think Apple, Google, Tesla, Netflix, etc…). As investors buy new positions they will often gravitate to similar companies and before they know it they own several companies in the same sector/market cap. The ‘Tech Bubble’ was not that long ago and it had a profound impact as investors over-weighted their portfolios with technology stocks and felt the impact. The NASDAQ lost -78% of its value over an 18-month period as it fell from 5,046.86 to 1,114.11.

It is not unusual for a stock or sector to stumble from time to time, but if a portfolio happens to be over-exposed to a certain stock/sector it will have a huge impact on the overall account. If the portfolio were comprised of multiple positions, properly spread across both market cap and industries, it will typically perform better over a given time period. Many investors struggle with this concept as it is essentially stating that within a diversified portfolio there will positions that are ‘winners’ and ‘losers’. It is human nature to want to only buy the winners but research has shown that chasing performance essentially guarantees failure when it comes to investing. True diversification requires that an account have exposure to different asset classes, industries and geographic locations.

Over Diversification

Another side to diversification is the extreme of having too much of it. Warren Buffett is known for saying “ Diversification is protection against ignorance. It makes little sense if you know what you’re doing.”

Imagine if you had a $200,000 account that had 50 – 75 positions within it!? This is not that uncommon as firms will look to bring down the risk of a portfolio in an effort to keep their clients happy but what are they really delivering?   While they are certainly bringing down the risk associated with being overexposed to one position, industry or sector, they are also limiting the performance and upside potential. Even if a handful of positions were to post 100% rates of return in a year it would barely move the needle with overall account performance. Lastly, while a portfolio managed with tons of small positions and activity may seem “professionally managed”, it’s very likely that it is expensive, tax inefficient, and basically behaves (performs) like a glorified index fund. (i.e. doesn’t do much more than the broad market anyway) So where do we go from here?

ConclusionDiversification 1

Investors need to truly understand what their risk tolerance is and have it drive what their
target allocation should be.   By having a diversified portfolio, investors will be able to smooth out the overall ride of their portfolio. Legendary investor and author, Peter Lynch, coined a word to help describe how investors often address their portfolios – ‘DIWORSIFICATION’. This essentially is the process of adding investments to a portfolio that the risk & return trade-off is worsened over time. It is investing in too many assets with similar correlations that will result in an averaging effect.

If you are struggling with your portfolio or have questions on whether you could improve your diversification, ask us! You can contact us with the form attached to this article or by emailing us at: info@myportfolioguide.com, please type Diversification in the subject line. We offer all prospective clients a complimentary portfolio review and analysis.

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