Over or under diversifying remains one of the classic behavioral mistakes. Over diversification happens to us when we become collectors of investments versus investors. Think of the person who buys the mutual fund they read about inSmart Money. Next year they buy the Top 10 Funds recommended by Money Magazine. A year later he buys two or three new international funds because that’s what’s on the front page of Forbes. Before he knows it, this particular investor has a smorgasbord of unrelated investments and there’s no cohesive investing strategy at work.
Often with this approach, you end up with a bunch of investments that duplicate each other. This over diversification can lead to inefficiencies, including unnecessary taxes, internal expenses, transaction costs, and maybe most importantly the impact on your life in the form of the time you have to spend thinking about all those lines on your monthly statement. At this point, you need to consider an often overlooked, but relatively simple concept: each individual component of a portfolio should be there for a reason.
Think of each investment that you own as a thread in a larger tapestry. You shouldn’t buy individual investments because they appear on the cover of a financial magazine. You buy investments for what they contribute to your overall portfolio. It’s the overall portfolio that’s important and not the individual investments.
Being under diversified is an equally troublesome problem. Under diversification can take the form of owning a single stock. For instance, maybe you work at Apple, and you’re convinced that Apple stock can only go up, so you put your life savings into Apple stock. We’ve seen why this choice can be a bad idea (e.g., AIG, Enron, Tyco, Lehman, or WorldCom). While owning a single stock or a portfolio that’s concentrated in a single industry is one version of under diversification, I more often see people who own a number of mutual funds and believe their diversified. The reality is that fund overlap can leave you heavily invested in just a few individual stocks.
This happens because mutual fund managers tend to have similar ideas and create funds based on what’s popular at the time. If you look carefully at many of the largest mutual funds (the ones we’re most likely to buy) have significant overlap among the top ten holdings. You may think you’re getting broad diversification by owning ten, large-cap mutual funds. In reality you own a bunch of the same individual stocks.
Both of these examples demonstrate well-intentioned behavior. Whether you’re under or over diversified, you were most likely doing what you thought you were supposed to do. You’ve spent a lot of energy, time, and even money trying to do the right thing. Unfortunately your efforts have created the exact opposite of what you want to accomplish.
Over diversification creates unnecessary expenses while under diversification leads to greater risk because of concentrated investments.To avoid the traps of both, you need to assess what you’re doing compared to what you’re trying to accomplish. Remember: you’re not a collector, but an investor. You want stocks (or funds) that get you closer to the financial goals you’ve set for yourself. You also need to make sure that what you own doesn’t expose you to greater risk than you can handle, again based on your goals. The end result should be a portfolio that reflects your goals, not a collection of magazine covers.
This sketch originally appeared in the New York Times on Monday, November 8th, 2010.
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