Don’t ‘Deworseify’ When You Diversify

Robert HobermanManaging Partner, Hoberman & Lesser CPAs, LLP

For an investor, managing money is a lot like managing manure for a farmer. Both live by the credo, “spread it around and it will grow.” But as both successful investors and farmers know, you’ve got to know how and where to spread money and manure, or they end up yielding stinky results — or even getting flushed away.

While we can’t help with a manure problem, we do have definite thoughts about spreading money around — in a way that doesn’t cause your portfolio to take a turn for the worse when you try making it more diverse.

Diversification Basics

Anybody can diversify a portfolio. The problem is that it’s deceptively simple — and proper diversification is anything but. Investors typically make three types of diversification mistakes:

1. False diversification. Investors who “falsely” diversify know just enough to be dangerous and act on a vague idea that all eggs shouldn’t go in one basket. So they buy a lot of different stocks, funds or both – with no clue as to how to go about it. Operating under the illusion that they’re diversified, they are often highly vulnerable. Their decisions tend to result in a portfolio of investments that move in tandem. So in a down market, they get clobbered. Except for the high-rolling-conscious non-diversifiers, these investors were the most vulnerable to the market mini-collapse in the early 21st century.

2. Erroneous diversification. Some investors do grasp the concept of diversification, but don’t realize the mathematical complexity or attention to detail involved in achieving it. So they construct a portfolio of relatively uncorrelated investments, but fail to match its risk level to their investment objectives. Typically, these investors fail to include enough high-risk/high-reward areas such as global investments. Or, they fail to include an adequate small percentage of negatively correlated investments that hedge against traditionally turbulent markets — such as precious metals, oil and other commodities.

Erroneous diversifiers also don’t recognize the need for two levels of diversification — first at the asset-class level and then at the investments-within-class level.

Omitting precious metals is an asset-class error, while omitting international stocks is a within-class error. Because less experienced investors tend to limit their universe to stocks and bonds, they’re more likely to be under-diversified in asset classes. In fact, if they have diversification religion, their narrow focus on stocks and bonds might also lead them to the next diversification-error category.

3. Over-diversification. You’ve likely heard the adage: You can have too much of a good thing. So it goes with diversification. At a certain point, the law of diminishing returns takes over when adding new categories and new specific investments to portfolios.

For example, research has shown that a portfolio of about 20 stocks — carefully diversified in terms of company size, business risk, sector and other factors — is about the point at which little improvement can be made. Yet, you might wonder: Why not keep adding if you can still improve by even small amounts?

Here are some reasons:

Commissions. The transaction costs for buying 200 shares in one stock is much lower than what you’ll pay for buying 10 shares each of 20 stocks. As commissions add up, they require better investment performance to overcome them. The same principle often holds true with mutual funds. You’ll generally pay more in transaction costs if you invest $10,000 by putting $1,000 each in 10 funds, versus $2,500 each in 4 funds.

Diluted standards. Unless your income is rising dramatically, the funds you have to invest won’t grow dramatically, so each new investment will seem less significant. Just as the second and subsequent kids in most families get less parental attention than the first one did, you might not be as thorough in later selections as you were starting out. Consequently, those later additions could under-perform and reduce your overall return.

Diverted diversification attention. The more distinct investments you acquire, the more overall work is required to ensure that your portfolio is serving your purposes. For example, perhaps you hold numerous mutual funds that you’ve thoroughly researched to ensure that they don’t generate excessive capital gains from frequent trading. But without your knowledge, management and philosophy changes could have led to higher trading levels and a bigger capital-gains tax bite — even though you don’t see overall gains that improve your returns. Or, the risk profiles of individual stocks or funds might have changed, and your overall portfolio risk no longer matches your objectives — possibly leading to deteriorated returns from either elevated risk gone bad, or risk-reduced limited returns.

Of course, coming up with a diversification plan to spread out your investments is a time and energy commitment that can leave most investors feeling they’re spread out too thin. This is especially true during down cycles. So give us a call and we can discuss your portfolio together.