The Truth About Being Well-Diversified

By Allen Kampf



We've all heard the saying that warns us to be careful about "putting all our eggs in one basket." When it comes to diversifying your portfolio, that adage is not only relevant, it could mean the difference between financial success and failure.

Sound investment diversification means choosing balanced investments so that your portfolio will not be heavily impacted by any one trend, event or setback. It involves taking time to identify short-term and long-term investment goals, and then setting a course to reach them through market fluctuations.



Which Risks Can Be Diversified?

Diversification works to reduce some risks, but not all. For example, you could own a Standard and Poor's (S&P) 500 index mutual fund that is well diversified among 500 large U.S. stocks. These 500 stocks are components of the index because they mirror the variety of the U.S. economy, including diverse regions and industries.

By definition, the S&P 500 Index is well diversified with regard to "stock-specific" and "industry-specific" risks. Yet, if you hold an S&P 500 Index fund through a deep bear market, you will probably lose a substantial part of your money.

The truth is, holding 500 large stocks still exposes you to the "systematic risk" of the U.S. stock market as a whole. Regardless of how many different stocks or stock mutual funds you add, you won't reduce this risk - and in fact you may increase another type of risk, which is the potential to underperform the market average.



The Value of Asset Allocation

The best way to reduce the "systematic risk" of stocks (or any other asset class) is to spread your money among several classes, such as stocks, bonds and cash. This can be accomplished through a disciplined program of asset allocation, which sets guidelines for each asset class based on the individual investor's return objectives and risk tolerance.

The next step is to diversify effectively within each asset class. For the portion committed to stocks, a few carefully selected equity mutual funds can spread money among a variety of industries and company sizes.

For the part committed to bonds, you can diversify among short-term and long-term maturities and also among issues with high quality and those with lower quality but higher yield.

Cash has a special purpose in an asset allocation plan for portfolio diversification. Since cash tends to produce more stable performance than either stocks or bonds, it is useful for adjusting overall risk.

Even in a terrible year for stocks or bonds (or both), a portfolio diversified partly in cash can emerge without major losses. This not only helps to maintain momentum toward long-term financial goals. It also helps investors maintain confidence.



Basic Questions

Here are some basic questions to ask yourself as you diversify your assets.

¥ What is my risk tolerance? The farther away in time your goals are, the higher your risk tolerance can be. Younger people have more time to recover from a setback than older people. Conversely, novice investors often want to build their confidence at a modest level of risk, which makes diversification even more important. Fortunately, mutual funds enable anyone to diversify among asset classes and investments, even with modest amounts of money to invest.

¥ How well diversified is my current portfolio? Many investors now own stocks through a variety of managed portfolios, including mutual funds, IRAs, 401(k)s, variable annuities and variable life insurance. It is possible that these portfolios as a whole are over-concentrated in one or two industries or even a few stocks. In some cases, it can make sense to select different portfolios that reduce concentration and increase portfolio balance.

¥ How wise is the investment today? All investment strategies have their day. Strategies that performed well in the past often fall out of favor in the future. The historical patterns that make specific investments attractive in one environment may not be repeated in the next phase. Each investment should make sense on its own, as well as in an overall plan for portfolio diversification.

Mutual funds can be a good way to diversify, but there are other solutions that also offer access to different markets, asset classes and professional management styles. They include variable annuities, variable life insurance and individually managed investment accounts.

In short, any investor can perform well when financial markets are rising. But usually, it's the well-diversified investor who emerges in the best shape after a downturn in the markets.



Allen Kampf, RFC, is a partner in Wealth Advocacy Partners (www.wealthadvocacypartners.com), offering comprehensive financial services including insurance, investment and estate planning and education planning services. He may be reached at 410-527-1171.