One of the first lessons investors are taught is to be diversified. In principle, diversification seems simple enough to execute: Don’t put all of your eggs in one basket but instead spread your risk across various sectors and asset classes. Simple though it may seem, true diversification is something many investors fail to accomplish.
True diversification reduces portfolio volatility, or “the stomach-churning ups and downs that can occur in the financial markets,” says Kimberly Foss, best-selling author of “Wealthy by Design: A 5-Step Plan for Financial Security” and founder of Empyrion Wealth Management in Roseville, California. But a portfolio that looks diversified may in fact be masking false diversification.
[See: Avoid These 8 Rookie Investing Mistakes.]
Your baskets are all alike. “False diversification is when investors distribute their eggs among a number of different baskets but don’t realize that the baskets are all very similar,” Foss says. For example, you may be invested in a dozen mutual funds and think yourself adequately diversified because each mutual fund holds hundreds of underlying securities. The more securities you have, the more baskets your eggs are in and the more diversified you are, right?
Not so fast, says Foss. If all of your funds have similar objectives or invest in similar securities, the baskets containing your eggs may be essentially the same basket. This could result in a “belief that a portfolio is diversified when a deeper look at the underlying holdings show an unintentional concentration in one or more areas,” says Justin Castelli, a financial advisor and founder of RL Wealth Management in Fishers, Indiana.
Don’t let positive returns fool you. It’s easy to overlook the signs of false diversification in a bull market. After all, if your entire portfolio is up, you must be doing well. Unfortunately, “if everything goes up at the same time, they’ll probably go down at the same time,” says Marc Odo, director of investment solutions at Swan Global Investments in Durango, Colorado.
Investors learned this lesson the hard way during the 2008 crisis, when it seemed there was nowhere to hide from the tanking market, he says. Before the crash, no one wanted to invest in gold or cash because other asset classes were performing better. But when things took a turn for the worse, the only investors who didn’t lose everything were the ones who had gold and cash in their portfolios.
The real problem is that investors’ assets are too highly correlated during financial crises. “When everything’s down, the only thing that’s up are correlations,” Odo says.
Correlation is the degree to which two assets move in tandem. It’s measured on a scale of negative one to positive one. Two assets with a correlation of negative one will move in opposite directions in response to the same event. Assets with a correlation of zero are completely unrelated, meaning that their performance is affected by different events. Meanwhile, assets with a correlation of positive one move in exactly the same manner. “If you have 11 funds and they all have correlations of one, you may as well have just one fund,” because they are essentially performing the same role in your portfolio, Odo says.
[See: 9 ETFs That Go Up When the Market Goes Down.]
When diversifying, investors should look for negative correlations between investments because this means they’ll have offsetting risks, he says. When one investment is down, another will be up, so the whole portfolio won’t fall at the same time. With a diversified portfolio, “you’ll never get all the upside, but hopefully you’ll never get all the downside either,” Odo says.
This is how to spot false diversification. One way to spot false diversification is by auditing your individual holdings. “If everything is up by similar amounts, that means you don’t really have diversification,” Odo says.
Next take a deeper look at your exposure to asset classes and market sectors. “Without knowing your asset class and sector exposure, you could be taking on much more risk than you realize,” says Kyle Ryan, executive vice president of advisory services at Personal Capital in San Francisco. “It’s incredibly important to understand how all your investments combine to create a diversified portfolio with balanced exposure to sectors and asset classes.”
There are different online tools investors can use to evaluate a portfolio’s diversification. Castelli says the most common tool for non-professional investors is Morningstar’s Instant X-Ray. It allows investors to evaluate their portfolio’s asset allocation and exposure across various sectors, geographic regions and investment styles.
Many investment firms also provide free online tools to their investors, such as Personal Capital’s financial dashboard, which enables investors to view multiple layers of their portfolio and spot potential false diversification. Investors can evaluate their overall asset allocation for stocks, fixed-income and short-term investments, as well as for international and domestic securities.
From there, they can take a closer look at their exposure to specific market sectors, like technology or finance. “To really understand your level of diversification, you have to dig a little deeper than the surface to grasp what makes up your holdings,” Foss says. “Then you can make informed decisions about how to gain true diversification.”
You can build a better portfolio. The way to avoid false diversification is to build a portfolio with negatively correlated funds that can help you accomplish your financial goals within your risk framework. “The most important aspect of diversification — and portfolio management in general — is ensuring that you have an appropriate asset allocation mix for your goals and time horizon,” Ryan says. Your asset allocation will be the primary driver of a portfolio’s returns and volatility.
[See: 7 of the Best Tech Stocks to Buy for 2018.]
Although a professional can help you research appropriate investments, Castelli says having a financial advisor does not absolve you of your responsibilities. “It’s important for investors to spend some time doing their own research, or at least review the research provided to them, to learn more about what they hold in their portfolio,” he says. Even advisors and investment managers can fall victim to false diversification.
More from U.S. News
7 ETFs You Have No Business Buying
The New Sector Funds: 10 Thematic ETFs
Why Investors Love Legacy Companies
Is False Diversification Lurking in Your Portfolio? originally appeared on usnews.com
