Most investors know that diversification is essential, so that when your stocks are down, your bonds may be up. The opposite of diversification is concentration, with the portfolio at risk of wild up-and-down swings.
But too many investors think avoiding excessive concentration is all they need. Even a diversified portfolio can have holdings that don’t properly balance potential performance and risk.
Achieving diversification is easy, balancing risk and potential returns is not.
“Diversification is one of the fundamental tenets of investing that should not be violated,” says Robert Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania. “The basic premise of not putting all of your eggs in one basket is sacrosanct, particularly for retirement investors. If you are undiversified you are, in effect, rolling the dice, gambling that you will win.”
But even diversified investors need to find a Goldilocks zone that is neither too risky nor too safe, and finding that balance is tricky.
[See: 10 Skills the Best Investors Have.]
“If [investors] are too aggressive, they don’t realize the type of declines they may experience when markets and economies turn down,” says Scott W. Cody, partner at Latitude Financial Group in Denver. “And the opposite is true as well, meaning they don’t realize they likely will not achieve their investing goals based upon the current portfolio construction along with their current level of savings.”
“The fact is we learned in 2008 that diversification does not equal safety,” says Ty J. Young, a financial advisor in Atlanta. “Every major asset class went down at the same time. Diversity did not work.”
Financial advisors say concentration is a persistent problem among clients who have picked their own investments without realizing that two funds with very different names share many holdings. In some cases, an index fund targeting a portion of the market may be full of stocks found in a broader index fund already the investor already owns.
Fortunately, addressing the problem has become easier over time — it’s not necessary to compare lists of fund holdings side by side.
Professionals employ pricey tools like Riskalyze, while ordinary investors can use ones like Morningstar’s Instant X-Ray.
But simply being alert to the issue can be a big help, and excessive concentration is easier to avoid than in the 1990s, Cody says.
“It was very common back then to sit with an investor and see that they owned five or six funds but half of them essentially owned the same thing, so there was a ton of overlap,” he says.
Funds are more accurately named today than they were years ago, Cody says.
“Back in the ’90s and early 2000s, fund names were all over the place and never came close to reflecting the investment strategy or what it owned,” he says.
Over the years, regulators have pressed fund companies to be more accurate and thorough in marketing materials, making it easier for investors to understand each fund’s strategy.
But owning two assets that are very different may look like diversification but still be too risky if they behave the same. Stocks and high-yield or “junk” bonds, for instance, tend to be highly correlated, meaning they move in tandem, Cody says.
“They both need a positive economic environment to do well and both tend to decline during recessionary periods,” he says.
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Another improvement, Cody says, is the rise of target-date funds, which are now the default investment in many 401(k) plans if the investor does not choose something else. Target-date funds typically own several other funds, and it’s up to the fund company to make sure they do not duplicate one another. Target-date funds are heavy on stocks for young investors and gradually shift to safer holdings like bonds with the approach of the target date, which usually is the investor’s expected retirement.
Not only do target-date funds provide diversification without duplication, but by changing their asset mix over the years they attempt to avoid being too aggressive or too conservative, given the investor’s age.
Experts warn, however, against being too reliant on the fund company’s calculations, which are based on the investor’s time horizon and long-term patterns of asset performance. A one-size-fits-all target-date fund cannot take account of factors like one’s willingness to take risk, health or access to other resources like a traditional pension. It could be too aggressive for some investors, too conservative for others of the same age.
There is no foolproof way to find the balance between aggressive and conservative holdings, because no one knows how the markets will perform. Other than putting everything into cash, which loses value to inflation over time, there was no simple way to avoid the meltdown of 2008, when virtually every asset class collapsed.
So the best one can do is play the odds by assuming that past patterns offer some indication of how various assets will perform in the normal ups and downs of the market.
Young recommends a traditional strategy called the Rule of 100 that involves subtracting your age from 100 — so that a 60-year-old would come up with 40.
“That (result) should be the percentage you have at risk in properly diversified, risk-associated assets (like stocks),” he says. “The balance, which is the percentage equal to your age, should be protected from stock market losses.”
Of course, fancier approaches can fine-tune the calculation and produce allocations for slivers of each class like foreign stocks, small-company stocks, corporate versus government bonds and so on.
Buy searching for “asset allocation calculator” you’ll find tools for guiding asset allocation, though these have limits, too. If the tool asks what you’d do after a 10 percent stock decline and you say “sell everything,” it will conclude you are averse to risk and recommend a conservative allocation that might make it hard to reach your goals.
A good human advisor, on the other hand, would probably study your entire financial situation and say you are worrying too much about a normal correction, and urge you stick with a more aggressive asset mix. A professional also would consider other financial factors.
“We advise our clients to allocate a portion of their assets to things that provide guarantees and are uncorrelated to the other markets,” says Keith Friedman, founder of FBO Strategies in Stamford, Connecticut. “We usually recommend whole life insurance, which increases in value every year unlike a bond fund or, potentially, a bond. We also recommend the use of annuities because the guaranteed income they provide is a stabilizing force, especially in retirement.”
[See: 7 Stocks That Soar in a Recession.]
The bottom line is there’s no real substitute for knowledge and judgment. If you don’t want to bone up on investing dos and don’ts, it may be best to hire a pro.
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For Investors, Diversification Is Not Always Enough originally appeared on usnews.com
