Blogs > Your Money

Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Sunday, September 5, 2010

So You Think You’re Diversified?

Probably the most important thing to remember about investing is that high returns generally involve higher risk and taking on lower risk generally results in lower returns. That raises the question: Is there a way to increase returns without increasing risk? The answer is: Yes, there is. It’s called diversification.

Properly done, diversification can increase the returns of your portfolio and at the same time, lower risk. In his book, Asset Allocation: Balancing Financial Risk (Dow Jones- Irwin, 1990), author Roger Gibson gives examples of the returns of what he calls traditional portfolios (consisting only of T-Bills, long-term corporate bonds, and stocks in the S&P 500) versus more broadly diversified portfolios (that additionally include international bonds, small domestic stocks, international stocks and real estate investment trusts).

Over 10-year periods ending in 1985, the traditional portfolios returned 13.9 percent while the more broadly diversified portfolios returned 15.3 percent with significantly less risk, as calculated by the statistical measure known as standard deviation. Over the sixteen-year period ending in 1985, the return of the more broadly diversified portfolio was even better, with lower risk.

Obviously, there are limits to how much you can increase returns while at the same time lowering risk and there is no guarantee that in the short term every approach to diversification will result in higher returns with lower risk. Never the less, broader diversification over the long run, if done properly, will likely yield positive results. It is important, therefore, to make an effort to effectively diversify your portfolio.

Effective diversification requires that your portfolio include a number of distinct asset classes. Our client portfolios, for example, include eleven asset classes, including cash equivalents, short-term bonds, high-yield bonds, large-cap domestic stocks, international stocks, to name a few.

We often hear people say: “I don’t invest in mutual funds, I only invest in stocks”. Many financial advisors generally consider eight to ten large-cap stocks to provide adequate diversification for that asset class. However, in order to include small cap domestic stocks and international stocks requires that you research twenty-four to thirty stocks in total, to be broadly diversified in just three asset classes. That’s a lot of work and requires skills that the average investor lacks. Exchange traded funds (ETFs) and mutual funds can provide a way for the average investor to achieve diversification.

In order to include eight to ten diversified asset classes in your portfolio without using mutual funds or ETFs, you would have to research eighty to a hundred different individual investments. For the do-it-yourself investor, this can be quite a daunting task.

When clients come to us, they often have a rather large number of mutual funds in their portfolio. Often there are multiple large company domestic stock funds, multiple international stock funds and so on. They believe they are broadly diversified but in reality may only have three or four distinct asset classes in their portfolio. Certainly, this is better than just a couple dozen stocks and a few bonds, but it doesn’t constitute broad diversification. Multiple large stock funds often include many of the same stocks. This can lead to higher-than-desired concentrations of several stocks and can add significant risk to your portfolio.

In summary, broad diversification across multiple asset classes can help increase your returns and lower risk. To do so however, it must be done properly. If you are unsure of how to do this, we recommend you see a competent professional advisor.


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