How many different flavors of ice cream can you name?
Now, how many different brands of ice cream can you name?
What does ice cream have to do what investing?
First a definition of diversification. According to the website Investopedia.com, since we all search for our answers online. Says,
“Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.”
You’re probably thinking, we’ll that’s great — but I already have a ton of investments in my portfolio so I must be diversified.
Asset Allocation as a Diversification Strategy
Let’s go back to our list of ice cream brands. If you choose vanilla as your flavor, you would probably agree there are many variations among many brands. But they’re still all vanilla.
Could you have a preference over which brand of vanilla is better? Sure, but that’s irrelevant for now.
Let’s move this example of having the same flavor over various brands to investment funds. If you owned multiple funds with the same objective — it would be like choosing multiple brands of the same flavor. Sure you might have some variations in preference, but you would still only have a freezer full of vanilla.
Unfortunately, funds don’t always stick to just vanilla or chocolate. Some funds already have investment variations that appear in other funds — which would lead you to believe that you have a well-diversified portfolio — when in fact you don’t.
Diversifying Fund Managers
This doesn’t mean that you haven’t achieved or can’t achieve diversification. I’m just simply pointing out that you might not have a diversified portfolio just because you have multiple positions.
Holding three large-cap mutual funds or ETFs in your portfolio would be like owning three flavors of ice cream. If your intent was to diversify based on diversifying your asset classes — this would be the incorrect way to do it.
On the other hand, if you choose to allocate, say 15% into large-cap stocks and use three positions at 5% each then that would be a different story. Is there a point of over diversification — probably. There are academics who believe there is a point of diminishing returns.
Diversification of Firm Risk
Another way to think about diversification would be to place your money with various firms or banks. Diversification in this sense can provide protection from the institution going under or out of business. However, the institution should have certain account protections to protect your money up to various limits. So, this type of diversification that is often associated with reducing market risk would be incorrect.
Whatever way you choose to use diversification, just make sure it’s in the correct context. When you’re building your portfolio, it’s important to ask yourself why and how you are building it. Does it align with your goals? Are you being realistic in terms of risk and reward? And are you diversified correctly?