Importance of Diversification

Do you track your investments?  Are you diversified?  Are you too diversified?  These are some of the questions we must ask ourselves when we are investing in 401(k) accounts, brokerage accounts, or IRA’s.  While all financial planners will advise their clients to become diversified they also warn against becoming too diversified.  There are risks with both aspects of this and they are basically the same, by being under or over diversified you may actually increase your risks and decrease your returns.  How do you keep an eye on things and not get to a position where you are over diversified then?  Keep a watchful eye on these areas and keep these issues in mind while you invest your hard earned money.

If you worked at three different jobs you very well may have three different 401(k) plans in your name.  While it is very possible to have a diversified portfolio within a 401(k) account and even within three 401(k) accounts you have to know what is in each account.  Say you invested all three in the same fashion you should be diversified to a degree as no one plan is exactly the same as another.  However, if you say invested each 401(k) plan in blue chip stocks or larger firms that would make up the S&P 500 you are not really diversified as you own the same stock just in three separate accounts.  Also if you were to chase returns you would find that one year you may have invested in international equities and the next in small and mid-cap equities in the US.  Many people tend to invest this way in their 401(k) plans as they offer ease of investment changes and the fees are generally fairly low.  But as you can see just because you have three different 401(k) plans depending on where you invested the money within them will determine if you are diversified, not the actually number of accounts.

If you do find yourself in a position where you have say several 401(k) accounts, a few IRA’s and say some brokerage accounts you must look at all of them as a whole picture and not as individual accounts.  With today’s investment choices it is very easy to buy 10 different ETFs or mutual funds.  But by doing so are you really diversified?  In order to determine the answer to that question you will have to examine what the different funds you own invest in.  A fund in the S&P 500 may share similar equities with a fund that is invested in growth and that fund may have similar equities as a fund that invests in technology.  As you can see there are three very different investment strategies but when you look at what the fund actually owns it may paint a picture that looks very similar to the others.  When you invest in funds it is important that you as the investor understand what the fund invests in and what its investment strategy really is.  In many instances funds that sound vastly different are in fact, very similar to others.  That is why it is imperative for individuals to do the research into their investment choices and know what each is made of.

If your portfolio is large enough you can diversify by owning individual stocks.  In these instances I would say the average position in each equity should be at least $5,000 and there should be 20 to 30 different ones.  That will allow you as an individual investor to invest in enough different companies that can be spread over several asset classes and industries.  While people tend to invest in sectors that they understand it defeats the purpose to invest in 30 different companies if they are all tied to say technology.  If you did this you are not diversified at all and rather you would be concentrated in a single sector or industry.  Never a good thing.  And also the reason I stated a position of at least $5,000 in each investment within your portfolio is that way it is large enough that any changes will indeed make a difference.  Also, if you invest in individual equities, ETFs or mutual funds you need to be able to reposition and do asset re-allocation when things get too far out of balance.  This is important as it has been shown that by rebalancing your assets you will actually increase your overall returns.

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