We all know that we’re supposed to diversify our investments. It’s the “Don’t put all of your eggs in one basket” rule. If you spread your investments around, you’ll reduce the risk of losing money because when one of your holdings moves lower, another is likely moving higher. For example, bonds usually move higher when stocks move lower, and vice versa.
We know we are supposed to diversify, but a lot of investors don’t do it very well. As a financial planner and investment advisor, I’ve reviewed thousands of portfolios over the years. I often find that the account owner thinks that their portfolio is diversified, when in fact it is not. Of course, this doesn’t apply to the owner of the portfolio I recently reviewed who was 100% invested in the stock of the company he works for. He knew he wasn’t diversified but was comfortable with his (high-risk) allocation decision. This post will highlight some of the most common diversification mistakes investors make without realizing the error of their ways. Then I will give some ideas on how we think a portfolio should be constructed.
One of the most common diversification mistakes I see is when someone owns several mutual funds and thinks that, because of the number of funds they hold, they are diversified. They might hold a S&P 500 fund, a large-cap growth fund, a large-cap value fund, and a dividend growth fund. Four different funds should provide good diversification, shouldn’t it? Not really. If you looked at the stocks that are held in each of those funds, you would find that they are all invested in the same asset class—large U.S. companies.
Another common mistake I see is when someone owns an S&P 500 fund and a bond index fund and thinks that they have a good mix of stocks and bonds. This example is better than the first one, but the mix is still not providing good diversification benefits. The S&P 500 fund provides exposure to the 500 largest companies in the U.S. but none of the 2,500 or so other publicly traded U.S. companies. There’s also no exposure to international stocks or bonds.
When building a portfolio, it’s important to look beyond the borders. “Home country bias” refers to the tendency of investors to focus on the investments within their own country. For example, U.S. companies make up about 50% of the total market capitalization in the world, yet the average U.S. investor holds about 70% of their portfolio in U.S. holdings. A recent study in Sweden showed that investors in that country put their money almost exclusively into investments from Sweden, even though their country makes up about 1% of the world’s capitalization.
When building an investment portfolio, we focus on diversifying across the various asset classes. The first step is to determine the percentage that should go into the largest, broad-based asset classes—stocks and bonds. A conservative investor might have 30–40% of their money in stocks; a more aggressive investor might have 60–80%. The balance would be allocated to the bond side of the portfolio.
The next step would be to allocate geographically. We like to see about 50–60% of the stock allocation go into U.S. stocks, representing the U.S. capitalization mentioned earlier. Next, we would allocate between 25 and 30% of the stock allocation into international developed countries in Europe, Australia, Asia, and the Far East. We invest the remaining stock allocation into the emerging-markets asset class, which gives us exposure to companies in China, India, and other developing countries. We would follow a similar approach with the bond side of the portfolio, with more exposure to the U.S., which makes up about 60% of the world bond market.
Finally, we want to diversify within the geographical asset class. We want to spread our investment dollars across companies of different sizes. We want to make sure we have exposure to large, medium, and small companies in domestic, international, and emerging markets.
Diversification reduces risk in a portfolio by allocating investment dollars across asset classes, countries, and industries. The goal is to maximize returns by lessening the chance that a major market event would have a devastating effect on an entire portfolio. That’s why it’s so important to get it right.