Diversification is a buzzword that constantly pops up in regards to investing. In theory, the concept seems simple — you spread your investment capital over a sufficient number of securities, and in enough asset classes, that you avoid taking a complete bath when the market declines. But theory and reality are two very different concepts.
As a result, diversification can be more than a little bit tricky to achieve.
How can diversification end up going in the wrong direction?
1. Multiple Asset Classes Aren’t Mutually Exclusive
For many people, the name of the game with investing is growth. As a result, they find themselves with a portfolio that’s heavy in growth-type investments.
If you’re an investor who is young and considers himself to be aggressive, you may have 100% of your portfolio diversified in different stock sectors. The portfolio may be adequately balanced between large–, mid–, and small cap-stocks, technology, and emerging markets, with some portion also invested in growth/income stocks (in lieu of fixed income assets). All the while thinking you’re well diversified.
And you are diversified, but the problem is that you’re diversified in a portfolio that is 100% stocks. Without a doubt, you’ve achieved excellent diversification within stocks, but you’re holding nothing to counter the risk of an across-the-board decline in that asset class.
2. Emotionally Invested at the Wrong Time
Intellectually you know that you need to diversify, but there is a strong emotional component to investing, and it sometimes overwhelms your best intentions.
When stocks are rising strongly, you may be tempted to favor them in your portfolio. At the opposite end of the spectrum, if stocks take a beating for couple of years (as they did during the 2007 – 2009 period) you could easily get gun-shy, and invest most or all of your money in cash, cash equivalents, and fixed income investments. But either allocation is wrong.
Even though you know you need to diversify across several asset classes, emotions based on the circumstances of the moment, could cause you to go too far in a single direction.
Still another way this could come about is through neglect. You might fail to rebalance your portfolio after a strong run-up in a certain asset class.
3. Entirely Avoided Certain Asset Classes
Some investors might limit their investment choices unnecessarily. For example, they may consider only an allocation between stocks and fixed investments (cash, bonds, and other fixed income assets). In the process, they might entirely avoid asset classes that can perform well in certain market situations.
Examples could be real estate investment trusts (REITS) or resource investments, such as energy and precious metals. In certain markets, these asset classes could outperform both stocks and fixed income assets. But if you only diversify between stocks and fixed-income investments, you can miss out on these opportunities.
4. Investments Don’t Follow a Script
This is perhaps the biggest monkey wrench in the engine of diversification. We often assume that if we are properly diversified, then our portfolios will rise — or at least not get clobbered — by virtually any type of market. But this is really where theory and reality part ways.
In certain market situations, nearly all investment classes are falling at the same time. Stocks, bonds, and commodities can all drop simultaneously, where even a substantial position in fixed-income assets still results in an overall loss of your portfolio’s value.
A perfect example of this, is a time when interest rates are rising sharply. An extreme example of this type of market occurred in the early 1980s — when interest rates moved well into double digits, stocks, bonds, commodities and even real estate lost value.
The only way you were able to protect yourself in that environment, would have been to be 100% in either money markets or short-term treasury bills. But that’s not diversification.
5. Too Many Accounts
If you maintain three or more investment accounts, your efforts at diversification might be undermined by confusion. And the more accounts that you have, the more muddled the situation is. The problem can come about by having duplicate investments in the different accounts, such that you are overweight in certain asset classes, or even in specific investment securities.
You could be very well diversified in one account, but very poorly in the others. This situation can easily happen to a married couple, each of whom have a 401(k) plan and an IRA, and one or two non-tax sheltered investment accounts. When adding up the positions in all your accounts, you may find that you’re not well diversified at all, but because of the sheer number of accounts, that problem exists under your radar.
6. Diversification Overkill
So far we’ve discussed situations that would cause you to be inadequately diversified, but there is another problem that comes from a completely opposite direction, and that is diversification overkill.
Perhaps as a result of trying too hard to minimize risk — or even from confused thinking — you could diversify so totally, that you compromise your total investment returns.
Where you could adequately diversify within a single asset class with say, five separate holdings, you instead spread your money across 20 different investments within the same class.
By doing so, not only could you be hurting potential gains, but you will almost certainly be incurring excessive transaction costs. Either situation will hurt your returns and defeat the whole purpose of diversifying.
The secret with diversification is balance, but you have to balance it just right. That’s the tricky part, and not at all easy to do!
What’s another complications that comes with diversification?