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. You can reach us by using the contact form below. Please enjoy reading this article. Thank you!

Step 3 – Always own a fully diversified portfolio

A fully diversified portfolio is a key contributor to improved investment risk management and a more certain path to wealth. Diversification has become an axiom of personal investing, because variability associated with the specific risks of businesses and other investment entities can be reduced or eliminated through a diversified portfolio — without reducing total expected returns. Diversification genuinely is an investment “free lunch.”

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. Stay in the markets through thick and thin, while investing with an asset allocation that is appropriate for your greater or lesser tolerance for investment risk.

The best investment strategy is to seek complete market diversification at the lowest investment cost using passively managed and globally diversified index mutual funds. You can reduce the volatility of your personal portfolio significantly and track the return of the market with relatively small investment costs. Other strategies tend of be sub-optimal, involving greater portfolio volatility and risk — and accompanied by higher costs in term of expenses, taxes, time commitment, and stomach acid.

Nothing that has happened in the credit crisis changes the value of broad market diversification. Some uninformed post-crisis commentary has questioned the wisdom of diversification, which only indicates a failure to understand what diversification can and cannot do for you.

Diversification across a portfolio mitigates volatility over time

Diversification across a portfolio can and does mitigate volatility over time. However, when systemic factors across asset classes are in motion in the securities markets, then there is nowhere to hide, as occurred with the credit crisis. As over-leveraged investors across a wide variety of asset classes scrambled for liquidity, selling pressure increased broadly, buying demand collapsed, and asset values crashed generally, albeit, not uniformly. Those who were very broadly diversified felt less pain, but they still felt pain.

However, if you really like the potential for a lot more pain, then go ahead and don’t diversify. Sooner or later, that pain is much more likely to come to an ill-diversified investor’s portfolio compared to the portfolio held by a broadly diversified investor.

Of course, ill-diversified investors chasing tactical and active strategies are always hoping for outsized returns for the added risk. Sadly, only a minority of active investors trading in and out of the market will get lucky, and it is largely luck (of the lack thereof) that is at play here. The percent of the lucky minority achieving excess returns tends to diminish with time — as excessive fees and taxes cumulatively eat away at illusory excess returns — proving the foolishness of active strategies.

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 do not compensate through better returns. When you are less than fully diversified, your investment portfolio risks are higher than they need to be without any reasonable expectation of getting additional returns.

When you a) chose an active management strategy versus a passive one, b) try to time the markets versus staying put, c) buy individual securities versus funds, d) 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 this gives you less certainty that you will reach your goals. You might overshoot in performance if you are lucky, but you are far more likely to underperform, because of the various higher expenses, higher costs, and higher taxes that cumulatively drag down active strategies. The longer your time horizon the greater the chances that you will fall behind a passive, lowest cost, market index 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 much 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 tribute the financial services industry with 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.

A fully diversified portfolio is an absolute investment necessity. 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 going the charade of potentially beating the market.

However, when you buy individual stocks and bonds, you are less than fully diversified, and you are exposed to more risk. Plus, you 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 this kind of investment counseling and financial advice.

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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?

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 truly independent financial planner and fee only investment advisor

(Concerning compensation, I provide financial planning services only on a hourly fee or fixed fee for service basis, under a contract that we agree upon. You do not have to pay any asset fees. In addition, to avoid all conflicts-of-interest, I never accept compensation or commissions of any kind from the financial industry.)

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