“Don’t put all of your eggs in one basket.” I’m sure you’ve heard that expression before. Most people at least understand the idea of diversification. The idea is to prevent you from losing all of your investments if something bad were to happen.
The idea is simple, but many investors fail to achieve true diversification in their portfolio. I can’t tell you how many times I have heard someone talk about their diversified portfolio that consists of 10 stocks. Ten stocks isn’t anywhere close to diversified. This false sense of diversification is a very popular financial weakness that many adhere to. To have a truly diverse portfolio that mitigates risk, you need dozens or even hundreds of investments across different industries, currencies, geographic regions and asset classes.
The Value of Mutual Funds
The same group that calls their 10-stock portfolio diversified is the same group that scoffs at mutual funds. They say something like, “why would I pay a fund manager to pick my investments when I can do it myself just fine?” Even giving them the benefit of the doubt that they have the same expertise as a fund manager who’s full time job is to evaluate investments, how can one individual keep up with dozens or hundreds of investments necessary to be truly diversified? What kind of capital does it take to hold that many positions?
Natalie Cooper of BankingSense.com says, “Put simply, a mutual fund gives investors the ability to invest in cash, bonds, stocks and other securities while never requiring investors to make separate trades or purchases. To build a portfolio that has a similar level of diversification, an investor would need $100,000 or more. A mutual fund provides the same level of diversification for far less money. An individual investor can obtain great diversification with about $1,000.”
It’s true that there is a cost to investing in mutual funds. Depending on the fund type, there may be an up-front fee with smaller annual management fees or the fund may be no-load, but carry a higher annual fee. Regardless, the fees on most funds are nominal and the benefits easily outweigh the costs.
Avoiding False Diversification
Even if your portfolio consists entirely of mutual funds, you need to take care to avoid overlap. Kent Thune of About.com says, “This [investing strategy] has great potential for overlap, which occurs when an investor owns two or more mutual funds that hold similar securities.” He goes on to provide an example of two funds, the Vanguard S&P 500 Index (VFINX) and Vanguard Growth Equity (VGEQX), who’s portfolios consist of 97% of the same investments.
Buying a number of highly rated mutual funds isn’t enough to make sure you are truly diversified. You need to review the portfolios of each to make sure there isn’t any overlap. Your investments should also cover multiple asset classes. Laura Dogu of Forbes.com recommends a simple strategy to achieve this, “The three funds you should own now are the Vanguard Total Stock Market Index fund, Vanguard Total International Stock Market Index fund, and the Vanguard Total Bond Market fund…With only these three funds, investors can create a low cost, broadly diversified portfolio that is very easy to manage and rebalance.”
A good portfolio provides opportunity for growth while mitigating risk. Your level of risk aversion combined with the amount of time that you have to invest will dictate your proper portfolio mix. You can even include single stocks in your portfolio, but they should be a small part of your overall investments.
It’s easy to get blinded by the potential for high returns. A bond with a 5% coupon doesn’t look very enticing when compared with an emerging market that’s seeing 20% or 30% growth; however, high return investments cannot be separated from their risk. You need a balanced portfolio that’s truly diversified. You need to provide opportunity for your money to grow, but you need to make sure that it will still be there when you need it most.