Diversification is an investment term most are familiar with, and it’s an issue all investors must confront. Most simply, it’s the act of spreading risks out with the goal of improving one’s overall risk/reward ratio. But in an effort to do just that, many investors end up “di-worse-ifying” (thank you Peter Lynch, famed portfolio manager of the Magellan Fund in the 1980s, for coining the term) their portfolios and hurting their risk/reward profile. Scary thought: I have yet to encounter a prospective client portfolio who wasn’t diworsified in one way or another. So what am I talking about? Below I identify four of the most often seen mistakes made by professionals and non-professionals alike.
- Too many funds/strategies with a similar focus. Why does a portfolio need three US large cap value mutual funds in it? At that point you probably own so much of the large cap value market you should just buy an index fund and be done with it. Research shows that owning more funds within a market segment actually reduces the likelihood that you will outperform in that space. The only time this diversification technique makes sense is if your goal is to transfer your wealth to as many different firms as possible. Instead, you or your advisor figure out what focus areas you want in your portfolio, do the research up front to find the strategy that you have the most conviction in, and commit to it. Anything else is lazy, indecisive, and ignorant.
- Diversifying with funds of funds or separately managed accounts. This strategy is the previous mistake on steroids. Not only are you giving up all control of your portfolio by outsourcing allocation, security selection, and manager selection to third and fourth parties, you are also adding in a layer of fees. Funds of funds are by definition lacking in any direction or overall wisdom since each manager within the fund of funds is singing his or her own tune. There’s even a chance that they all end up owning a whole bucket of the same thing, so instead of diversifying you may actually be concentrating your portfolio in unintended ways. And since they each charge a fee, and then the fund cobbling all the sub-advised funds together gets its fee, you pay twice for the freedom to give up your freedom. And don’t be fooled by the sales pitch of getting “access” to great managers under one strategy – if they were so great they wouldn’t need to be part of a fund of funds and, in reality, they’d be closed to outside investors anyway. Plus, access to managers isn’t the problem folks make it out to be. So avoid this marketing gimmick unless, again, your goal is to enrich others.
- Diversifying across several advisors. It seems rational to avoid putting your nest egg in one basket by diversifying across a few different portfolio management firms. However, doing so is just a way of avoiding the un-enjoyable work of figuring out who is actually the best at what they do and/or executes a strategy that makes the most sense to you. It doesn’t actually reduce your risk, but instead it increases complexity, anxiety, confusion, and costs. Finding the best portfolio manager for you is tough even for folks who understand this business, but it’s not impossible and it’s incredibly important to make the effort up front. I will discuss investment manager selection in a later post, but for now I’ll just say do the work, commit to someONE (even if it’s yourself), and you and your portfolio will be glad you did.
- Diversifying across too many asset classes. I saved the best (worst?) for last. The most frequent, but contentious, mistake I see in others’ portfolios is the attempt to diversify a portfolio across WAY too many investment categories. No kidding, I once saw a portfolio that invested across over thirty different mutual funds with only minimal duplication (the first mistake I mentioned)! Few in this industry will admit that the majority of what are termed “asset classes” are not at all helpful for most investment portfolios. The truth is that you can do a fine job investing in as few as two very broad asset classes, and arguably better with just a small handful of perhaps 6-8 more finely tuned asset classes. The usual asset classes to avoid include: commodities, currencies, most categories of bonds, all hedge funds (which are not even an asset class), private equity, venture capital, and I’d argue even the growth and value categories of stocks (stocks are great, it’s the distinction between growth and value that is unhelpful). So if your entire portfolio has a list of securities that requires more than a fraction of a page to list, you are probably diworsified.
The really disappointing thing is that there are plenty of investor portfolios out there making all four of the above diworsifying mistakes. They own what I call a “kitchen sink” portfolio and when you have a little of everything, you get a lot of nothing. No, that’s not true…what you get is a lot of expense, complication, friction, and headache if you are even aware of the monster that was created. So if you are diworsified, do yourself a favor and pare down your portfolio to only those investments that serve a specific, intended, research-supported purpose, that are inexpensive and transparent, and are predictable and manageable. And make sure they are stocks (blended rather than growth vs. value), certain types of high quality bonds, or cash. You really can properly diversify your portfolio across thousands of non-overlapping securities in productive global markets with just a few holdings and for practically nothing. Such a portfolio diversifies all diversifiable risks so that what’s left are the well-chosen risks you intended and that hopefully will reward you over time. That kind of portfolio, I argue, has a far better chance of achieving one’s investment goals with far less stress than any diworsified portfolio might.