By Dustin Giannangelo
CEO Fusion Wealth Management
Many people know the importance of having a portfolio that is well diversified. However, they often remain unsure about diversification when it comes to practical application for their investments. With so many investment options offered it makes people’s lives more problematic when it comes to implementing proper diversification. Understanding these nine myths about diversification is imperative.
When looking at all the available investment options in your 401(k) or a brokerage account, it is quite overwhelming to attempt to do due diligence with so many options. In the face of such complication, most resort to generic rules of thumb when it comes to deciding how to implement diversification best.
When people rely on information that is not factual, it leads them to believe in myths that could damage their investments. Below is a compilation of nine of the most common myths and the truths to combat those misconceptions.
Many people know they should own multiple stocks to achieve maximum diversification, with 18 stocks being the cited as the rule of thumb. The thought is that the higher the number of stocks you buy, the more diversified you are, and the chances of market threats will decline to a minimum. This is yet another one of the myths about diversification.
In fact, all they have protected you from is a single stock risk but not the systematic risks (the risk that is non-diversifiable). Many people falsely believe when they are holding a substantial number of large U.S. stocks that they are diversified.
The Truth: You are only diversified if you own investments that move independently and the opposite of one another.
If you want to be truly diversified, you must find investments that move independently from one another. For instance, if you bought ExxonMobil and Chevron, that is not a very diversified investment.
You must uncover investments that are independent of each other through business cycles and across all market conditions. Even if you go with the conventional wisdom of having a mixture of stocks and bonds, there is no historical guarantee that they will move independently and in opposite directions.
Many believe that if you add more of a specific asset type to your investments, you will create diversification, which is false. They think by increasing their position size in positive trending assets will help improve overall diversification. However, when that asset begins to trend negatively, they will have found out that they have substantially increased their portfolio risk, not diversified.
To complicate matters even more, people tend to get greedy and forget about attempting to diversify by over concentrating only a few investments. Emotional thinking such as this can create increased risk because the investments they are overloading into have the same underlying risk factors and exposures.
The Truth: You only achieve limited diversification when you increase the same type of assets in your portfolio.
It is exciting to find potential new investments, but if it is the same type of asset already in your portfolio, it will likely create marginal benefit when it comes to avoiding one of the myths about diversification.
The same principle applies to the addition of a new asset into your account. The investment may be uncorrelated, but when it is not weighted correctly inside the portfolio, it makes a negligible difference to the overall account holdings.
The prevailing wisdom out there is that one has a proper amount of diversification in their investments if they hold alternative assets like hedge funds, private equity, commodities, and currencies. People commonly believe that increasing the number of complex asset classes in their investments will help them achieve maximum diversity. Usually, people invested in these alternative asset classes are uneducated about the inherent risks, like high leverage and a lack of liquidity.
The Truth: Complexity does not equal diversification.
Adding a medley of alternative assets makes most portfolios more complicated, usually more expensive, and potentially less diversified. On top of that, investors could be increasing the risk of their portfolio without even realizing it. While it may be attractive, or even sexy, to invest in sophisticated investment vehicles or funds they usually provide investors with a false sense of security when it comes to avoiding yet another one of the myths about diversification.
There are various misconceptions regarding brokerage accounts. One of the most deceiving myths about diversification is that by having multiple brokerage accounts, it makes a person diversified in the markets. These people are confusing account diversification with the actual investments inside their portfolios.
However, one should not be concerned when investing in a brokerage account since SIPC Insurance covers them. If your account is below the SIPC threshold, which is $500,000 and a financial institution was to become insolvent, then your money would be protected. It does not mean you should deposit your entire assets in multiple brokerage accounts with different financial institutions to attempt to safeguard your money.
The Truth: The diversity of the underlining investments is more important than the variety of accounts.
Many people believe they are diversified when they invest in different “places.” For example, you could have many retirement accounts with multiple companies from your previous employer’s that you have accumulated over the years. Approaching diversification this way is not a successful route, and your investments may be at more risk. It is important to understand this is one of the common myths about diversification.
The investment vehicle that you use to make your allocation is only significant from a legal and tax viewpoint. These considerations are essential, but if you do not have adequate diversification in the underlying investment, your long-term returns will suffer.
It is essential to understand that diversification is not going to avoid all risks, neither can you assume it will always be successful. There will be time-periods where your investment will lose money for reasons beyond your control. It is imperative that you understand this when you implement a diversification strategy inside your portfolio.
The Truth: An investment strategy that is diversified can reduce some risk, but it will not eliminate the possibility of adverse returns.
Most investment risk can never be taken away entirely, but it can be limited in some situations. Diversification can modify the risk of a single individual investment in decline hurting your overall portfolio, but it cannot protect your investments from every negative situation. Even the most diversified portfolios experienced declines in the 2008 Great Recession. Diversification is meant to be implemented to reduce your volatility in your portfolio so you can achieve consistent returns.
Our intuition seems to point us towards having our investments across many financial service providers. People believe that by using multiple providers, it leads to better diversification.
However, this only silo’s off your investment managers and may cause them to overlap each other’s strategies. Therefore, creating unknown concentration risk inside your overall portfolio. Furthermore, this added layer puts you in a position to have to manage not just the investments, but the providers as well.
The Truth: Diversification is not created by using multiple investment providers.
When working with a knowledgeable wealth management team that knows your goals they can remove complexity and the concerns about overlapping investments. Also, you will have streamlined things by engaging with one company that can adequately diversify your investments. Having a Personal CFO or your Financial Quarterback that can invest in strategies and vehicles tailored to your unique goals is imperative.
Many people avoid investments that have historically high levels of volatility. They see volatility as something to be strictly avoided at all cost. They focus on the fear that this investment could cause instead of the long-term goals they have for their portfolio. While it may be unpleasant to experience substantial changes within your investment accounts over a few days, you can implement a diversification strategy that will help keep volatility to a minimum to help achieve your objectives.
The Truth: An investment that has minor volatility can be just a harmful as an investment that has a considerable amount of volatility.
To achieve your long-term goals, you will experience volatility within the markets from time to time. Many people find this uncomfortable, but if you are not willing to ride out the storm, you may not accomplish what you set out to do with your investments. You must pursue a diversified strategy that can help you achieve your goals by taking the proper amount of risk. Therefore, being diversified within the constraints of your goals, you will be able to sleep comfortably at night.
Some people believe they should invest only in companies that they know. For instance, a person may work in the software space, so they buy shares in well-known software companies. These investments do not lead to diversification and most certainly ignores correlation. Investing in what you know to create safety is one of the biggest myths about diversification.
This same myth applies to investors who tend to only to invest in their domestic markets. Investors who invest in one country create a lot of correlation risk and are not very diversified. Investing in multiple countries will allow you to hedge and diversify your country and currency risk inside your portfolio.
The Truth: Investing only in what you know will create over concentration and will not generate diversification for your portfolio.
When adding new positions to your portfolio, make sure that it does overlap with your existing investments. When adding a new investment, it needs to have enough weighting inside the portfolio so it will create an impactful balance with the rest of your investments. Placing a position in your portfolio that has a small percentage of weight will do little to diversify your portfolio.
Research shows most people typically divide their investment allocation equally amongst their assets. Regardless of the inherent risk, each investment has and the number of options available, people fall into this trap with a false sense of diversification.
For example, the average investor that has three stock funds and two bond funds in their portfolio will choose to weight each position equally, and they end up with a 60/40 percent stock/bond allocation. Those same investors, if presented with eight stock funds and two bond funds, would end up with an 80/20 percent stock/bond allocation. People tend to use a shotgun approach to their investments instead of drilling down to what the necessary amount of risk is that they should be taking to achieve their goals. Hence, they get caught in one of the myths about diversification.
The Truth: You should create a personalized risk analysis to make sure you are taking the right amount of risk. Therefore, you avoid one of the myths about diversification, and realize your goals.
Equal is not always better, especially in the world of investing. Different investments present numerous opportunities in your portfolio and looking at them in isolation would be a mistake. Creating a personalized risk analysis will allow you to produce the necessary amount of diversification. Therefore, helping you build a suitable portfolio.
Unfortunately, for many investors, there is no uncomplicated way around the complexity of choosing and managing investments for their portfolios. Figuring out the right amount of diversification for your assets is not an easy task. Understanding what the right amount of risk you need to take to achieve your goals will change over time. However, identifying the necessary amount of diversification is the first step that needs to be taken to have success in the stock market. Implementing the ‘Truths’ above will help you begin to think properly, and avoid the common myths about diversification.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Fusion Wealth Management, LLC is not affiliated with Kestra IS or Kestra AS. Kestra IS and Kestra AS do not provide tax or legal advice and are not Certified Public Accounting (CPA) firms. FINRA's BrokerCheck