If you hunted for eggs over the weekend, it’s likely that you did put all your eggs in one basket. After all, who carries multiple baskets around? While using one basket is fine for Easter eggs, it is not recommended for your investments. Diversification is a well-known facet of investing but how is it achieved and how can it go wrong? Our top tips for diversifying your investments are below.
1. Make a Decision: If you don’t have a significant amount of time, knowledge or desire to complete the due diligence required for proper diversification, consider delegating to a professional, whether it be a mutual fund or separate account with individual stocks and bonds purchased on your behalf.
2. Get to Know Your Funds: The challenge of diversifying through mutual funds is that the actual investments are wrapped up in the fund name. Although the name may allude to the types of investments (i.e., stocks, bonds, both) and/or their style of investing (i.e., growth or value) you won’t know what the mutual funds are actually buying unless you look. Quarterly holdings reports are provided for all mutual funds and ETFs. Compare the holdings in your mutual funds to make sure that you aren’t buying funds that essentially do the same thing.
3. Set Limits: If you choose to go it alone, don’t overextend yourself. The brightest minds in the industry will not profess to know all 500 companies in the S&P 500 and neither will you. We suggest that you limit the number of stocks you purchase to between 20 and 40 with no more than 4-5 within each sector of the market and no more than 5% of your total portfolio invested in one stock. It is probably a good idea to keep your bond purchases within the 5% range as well.
4. Don’t Overdo It: Diversification can go wrong on either extreme, too little or too much. There is such a thing as “over-diversification”. When adding additional investments to a portfolio, each additional investment lowers risk but remember: lower risk = lower return. Over-diversification occurs when an additional investment lowers the potential return of the portfolio more than it offsets the overall potential risk. Over-diversification can also be sectional in nature. Sectional over-diversification occurs when there are a large number of investments in a particular industry and the behavior of the investments is quite similar. Take, for example, Pepsi and Coke. The companies are similar in a number of ways so rather than buying both, we would recommend investing in the company that presents the best value.
Over-diversification is not only time consuming and inefficient, but it can also lead to costly trading commissions on a large number of investments that might ultimately reduce your overall return.
5. Consolidate: While it may have been necessary 30 years ago to spread money across multiple firms to achieve proper diversification, today you can buy the same stocks and ETFs through TD Ameritrade that you can through Schwab. Most large brokerage firms have selling agreements with the major mutual fund companies to offer their funds as well (i.e. Vanguard, American Funds, Fidelity). Diversifying across firms makes it increasingly difficult to manage your investments effectively. Putting together a clear picture of your portfolio and gauging performance will take a lot of manual work and tedious calculations from your statements. If you have accounts spread over multiple brokerage firms, think about consolidating. Work with your chosen advisor to determine what steps need to be taken and if there are any exceptions to transferability.