There are many ways to diversify a portfolio – if that is indeed the goal. But these ways aren’t all equal. Some diversification reduces certain risks, but leaves investors wide open to the very risks they often have in mind – the ones that made them want to diversify in the first place.
When you think of diversification, you may think of such things as:
- stocks vs bonds
- the 2035 fund that you own in your 401(k)
- the 6 stocks you own in your DRIP plan
- the 10 mutual funds that populate your IRA
Truth is other than stocks vs bonds (and maybe if you own a 2010 or 2015 fund), most of the above hypothetical examples will likely not diversify you away from too much market risk. And some of you may not want to reduce market risk. But for those that do, here’s what’s wrong with the other portfolios.
Stocks tend to be highly correlated these days, no matter if it’s a German stock, an American stock, or a Chinese stock. No doubt there are cases where this isn’t so and no doubt there are times in general when one country’s stocks are doing better than another’s. However, sadly these days stocks tend to move together more than they move separately.
A 2035 fund may be 70% stocks and 30% bonds – which offers some market diversification. However, the 70% in stocks is fully exposed to the market.
The 6 stocks in the DRIP plan are likely all large US companies that pay dividends. These have done well as the Fed keeps interest rates low and investors (especially big pensions) go looking for regular income in dividends. But these stocks will almost certainly rise and fall together on a weekly basis.
My favorite is the mutual fund example. I have encountered numerous people with myriad number of mutual funds that all invest the same way. They think because they have 10 funds they are diversified, when a simple beta analysis (comparing each fund to the S&P 500 index and each other) shows otherwise.
How do you get real diversification? I’m not sure people want it. Being the greedy folks that we are, we want to ride the beast as high as it will go. We don’t like it when it goes the other way, but that’s a worry for another day.
For those who really want diversification, you can look to foreign bonds, real estate, commodities, different trading styles and sometimes frontier markets (which are becoming popular). Adding these to a portfolio will add diversification, though some of these ideas might add a drag to your performance at the moment too.
If you want to explore real diversification, give us a call:
We’ll take a snapshot of what you’re doing and let you know if you have true diversification or just “nominal” diversification. If you are overexposed to the stock market or just right. Give us a call, we’d love to hear from you.