Search

What Investors Don't Understand About Diversification

The practice of diversification is as old a concept as investing itself.  It is the process of spreading your investments over several different investment classes.  In theory it is the way to reduce risk in your portfolio.


The problem is that diversification is often misunderstood. Here is what you need to know:


Diversification is not about the number of investments it is about the type of investments


I had a client come into my office one time and show me his 401 K statement. He said that his 401 K plan was well diversified. He proceeded to show me that he had his investments spread out over 9 different investments. I told him he had one problem. His nine different funds were all stock funds. Thus, he was 100% invested in stocks with no diversification.  Diversification is not about the number. It is about the type of investments. In theory, different types of investments don't react all the same way when it is comes to a risky market.


You need a lot of diversification to make a difference


An investor could think that a portfolio that has 80% in stocks and 20% in bonds is diversified. The truth is that you don't really start to gain the advantages of diversification until you start with 50% in stocks and 50% in bonds. 60%, 70%, 80%, or 90% in stocks don't give you a lot of coverage from risk. It is not until you have 50%, 40%, 30%, 20%, or 10% in stocks that you see a difference. Of course, the other percentage would go in bonds.


Real Estate Investment Trusts are not always a good diversification tool


Real Estate stocks or Real Estate Investment Trusts (REITs) are often touted as a good diversification tool in portfolios. The truth is that a REIT is a stock and in this environment most all stocks travel together, both up and down, giving you no diversification. Now, REITs that are not traded on the stock market could be a good diversification tool. Then again, you have your own set of pros and cons with privately held REITs.    


Diversifying between stocks and bonds doesn't always work


Stocks and bonds can both lose money at the same time. Although history would suggest that the probability of that happening is small, it is still a possibility. Thus, you need to keep this in mind.  


Remember when it comes to investments nothing works 100% of the time as Pop Culture Finance would have you believe.