Demystifying Diversification

I recently attended a networking event and overheard another attendee say, “I have my investments with three different firms because I don’t want all my eggs in one basket.” I hear this and other common misconceptions of investment diversification because most investors know they should be diversified but they’re not really sure what that means. I’ll break down the 4 most common myths and clarify how they can affect your portfolio.

1) “Don’t put all your eggs in one basket” means you should spread your investment dollars across and within various asset classes like stocks and bonds. It does not mean that you should spread your assets out over different brokerage firms. When you spread your investments across different brokerage firms (even if they’re in professionally-managed accounts), your various investment advisors or funds could be purchasing many of the same investments causing your investments to overlap. Overlapping your investments is essentially the same as putting your eggs in the same basket. As well, spreading investments across brokerage firms can make it extremely difficult to know where you stand with regard to your net worth, overall performance, and money movement. Consolidating your assets into as few places as possible and diversifying across and within asset classes is a better approach.

2) Over-diversification is a real thing. I once helped a client with a portfolio value of around $1 million simplify by selling over 300 individual stock positions. Each investment was worth less than $1,500, or about 0.15% of her portfolio. Through no fault of her own, this client had over-diversified. She had separated her IRA into 3 accounts, all being actively managed for a fee. Each account manager was then making small investments into a plethora of individual stocks. We consolidated all of the assets into a single IRA account and used the proceeds of the sales to purchase a handful of well-diversified funds. This made her portfolio much easier to manage and helped to keep her from being spread too thin.

Holding hundreds of tiny investments will wind up having little or no impact on the performance of your portfolio. You might not lose much on each investment, but you also won’t gain much. As well, if you’re managing your own portfolio, it will be nearly impossible to keep up with that many companies’ investment reports and make decisions about when to buy or sell. We recommend purchasing a mix of quality mutual funds or exchange traded funds that can leave the day-to-day buying and selling up to a team of professional money managers at a much lower cost and with much less confusion.

3) Diversification is not a fail-safe approach to investing. Holding a diversified mix of investments does not mean that you have insulated yourself from the possibility of loss. When you purchase an investment, you’re inherently taking some form of risk, which can come with the potential for losses. Using a diversified mix of asset classes with the right level of risk for your time horizon and comfort level can help you stay invested through the market’s ups and downs.

4) A diversified portfolio does not mean you can permanently put your investments on auto-pilot. When you initially set up your portfolio, you can leave it to grow for a certain period of time, but you’ll eventually need to rebalance. Different asset classes don’t tend to grow at the same rates, which means you can end up with more risk than what you originally intended. Rebalancing once every 1-to-2 years will give your portfolio enough time to grow and ensure that you aren’t making investment decisions based on short-term market movements.

- Margaret Gooley, CFP®, Worley Erhart-Graves Financial Advisors