Investment Diversification Strategy

10 Personal Financial Planning Steps in the Right Direction

This is one of the “10 Steps in the Right Direction” that make up The Pasadena Financial Planner’s personal financial planning and personal investment management process. For a summary of these ten steps, see “Your Family Financial Planning.” To find an in depth article for each step, just click the Pasadena Financial Planners Sitemap link at the top of this page. Also, you can reach us by using the contact form below. Please enjoy reading this article. Thank you!

Investment diversification is a genuine financial “free lunch.” Diversified investment funds are key contributors to optimal investment risk management.

Diversification has become an axiom of personal investing, because the specific risks of businesses and other investment entities can be reduced or eliminated from a portfolio without reducing expected returns. When you hear that you should diversify your investments, this means that you should diversify your investments completely and globally – now and always. The investment research literature repeatedly demonstrates that a fully diversified, low cost investment strategy is superior. Get diversified. Stay diversified. Be globally and fully diversified all of your life.

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Diversification is really not an option, if your goal is optimized, risk-adjusted personal investing. Diversification is not an optional part of family investment strategy, if that family wants to sleep well at night. When you are less than fully diversified, every day that you wait exposes you to investment risks that the securities markets tend NOT to compensate through better returns. When you are less than fully diversified, your investment portfolio risks are higher than they need to be without a reasonable expectation of getting any likely additional returns.

When you chose an active management strategy versus a passive one, try to time the markets versus staying put, buy individual securities versus funds, favor certain economic sectors versus full domestic and international diversification, etc., then you are much more likely to lose than to win. This is simply because the road you are taking is unnecessarily rough and unnecessarily winding, and you have less certainty that you will reach your goals. You might overshoot in performance if you are lucky, but you are much more likely to under-perform, because of the various higher expenses and costs that continually drag down active strategies. The longer your time horizon the greater the chances that you will fall behind a passive, lowest cost, market investment strategy.

A passive strategy targets a market return and can still be a bumpy ride — especially if you are not fully diversified globally and you have not adopted an asset allocation that is appropriate to your tolerance for investment risk. Nevertheless, the attendant risks are lower and potential variations are narrower than active strategies. Furthermore, passive strategies that drive down investment costs and expenses to the bare minimum are not continually burdened by repeatedly having to pay the financial services industry a much larger and undeserved share of your returns. It is hard enough to finish a marathon without carrying water for the financial securities industry at the same time.

Full global investment diversification using the broadest, cheapest, most passive index mutual funds and exchange traded funds (ETFs) is the most optimal strategy for the individual investor.

Few in the industry will tell you this, because a lowest cost, global, and passive diversification strategy is the least profitable to the financial services industry. The securities industry looks upon you as a naive “retail investor.” The industry trains its representatives to sell to you the most profitable products that it can at “retail” prices.

Through visible and hidden fees and other costs, these “retail” prices are heavily marked up to compensate the industry and its very highly paid sales force. Who do you think is paying for all those tall buildings, brass fittings, mahogany tables, woolen suits, and expensive silk ties? Who pays the industry’s huge salaries and bonuses? Does the money just come out of thin air, or does it come out of your investment assets and your investment returns?

Few will tell you this fundamental truth about the superiority of cheap, passive, fully diversified broad market investing. Everyone in the industry gets paid somehow, and there is far less profit in promoting a low cost, fully diversified investment strategy. However, there is real money in it for you. In the long run, you will tend to save more money, to save more time, and to save yourself from emotional consternation, when you use a very low cost, fully diversified passive investment strategy.

Complete investment diversification has become an axiom of personal investing, because the specific risks of businesses and other investment entities can be reduced or eliminated with a fully diversified portfolio without reducing your expected returns.

A fully diversified portfolio is an absolute investment necessity. Increased diversification reduces portfolio risk without a corresponding reduction in expected portfolio returns. Diversification is genuinely an investment “free lunch,” and it is a key contributor to improved investment risk management. A very high degree of diversification can be achieved through investing in a variety of low cost passively managed index mutual funds or exchange-traded funds. Such investments are also among the lowest cost investment vehicles available to individual investors in the financial markets. Given that this alternative is easily and cheaply available, the relevant question is never whether a portfolio should be fully diversified.

Through investments in broad-based index mutual funds and exchange-traded funds, diversification is relatively easy and inexpensive to achieve. Attempting to become broadly diversified through the self-assembly of a portfolio of a large number of individual securities is far more difficult and much more costly.

Portfolio self-assembly is much more likely to result in higher risk with returns that lag the market. Buying individual stocks and bonds instead of diversified funds provides you with no advantage whatsoever. The industry likes it, because individual securities trading generates fees and keeps the charade of beating the market going. However, when you buy individual stocks and bonds, you are less than fully diversified, and you are exposed to more risk. Plus, you also get to waste your money and time for nothing. Pay more and get less. What kind of value added is that? You are better off ignoring that kind of investment counseling and financial advice.

Also, see these articles for more about the value of diversification: “The value of diversification to individual investors” and “What is the cost to individual investors of sub-optimal portfolio diversification?” These articles are published on The Skilled Investor, and they report on important investment research studies on asset diversification. Note that The Skilled Investor is one of our sister publications, and it is the longest running of our family of websites.

A significant portion of a investment portfolio may sometimes become concentrated in a single investment security, which dramatically increases the overall risk of a personal investment portfolio.

While generally undesirable, there sometimes are unavoidable reasons for investment concentration. Unavoidable reasons for lack of diversification can include owning a private business or being a key member of a company management team who is required to own company stock by an employment agreement with the company. In such circumstances, you should seek expert guidance on possible ways to mitigate the risk associated with your concentrated investment position.

Nevertheless, for 99.9+% of investors, there is absolutely no good reason to maintain a high level of concentration in an individual security. Immediate steps should be taken to reduce the exposure. How many failed public companies like Enron and WorldCom do investors need to see crash and burn, before they realize that excessive concentration does not pay and can lead to very significant personal financial peril?

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