When Diversification Can Become Problematic
Diversification is an important part of investing for retirement. But what does it mean to properly diversify your investment strategy? In a nutshell, it means spreading out risk so your investment portfolio isn’t overly vulnerable to one sector or area of the market. Blending different types of investments can help reduce portfolio volatility and concentration risk, allowing you to enjoy a smoother ride while planning your retirement and working toward your long-term financial goals.
There are various methods to construct a diversified portfolio, but all should start with the right asset allocation—the mix of stocks, bonds, cash and other asset classes in an investment portfolio. Your asset allocation should be customized to specifically match factors personal to you: your health, investment time horizon—how long you need your money to last—and financial objectives.
Mutual funds can offer a convenient and effective way for some investors to achieve broad portfolio diversification. However, every fund has a specific investment mandate such as capital preservation, aggressive growth, income, etc. from which they rarely deviate. Their static nature doesn’t automatically guarantee the right level of diversification needed to reach your financial goals. Further, some investors might think owning multiple mutual funds in an investment portfolio means more diversification—but investing in many funds can expose your portfolio and retirement goals to unforeseen risks and inefficiencies.
Whether you use funds or invest in individual stocks, bonds and other securities, diversifying appropriately can be a crucial driver of portfolio management.
The Importance of Diversification in Retirement
A diversified portfolio holds asset classes with exposure to different parts of the market with varying degrees of correlation—such that some assets might move similarly while others won’t—limiting the risk of big swings in overall portfolio value. For example, if an investor has exposure to two negatively correlated areas of the market, assets on one area may hold steady (or even rise) whereas assets in the other may underperform. As such, portfolios with negatively correlated assets is better equipped to mitigate risk and volatility.
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What might happen if you aren’t diversified? Suppose the bulk of your retirement portfolio is allocated to oil price sensitive stocks. If oil prices fall, the value of these stocks will likely decline as a result. Had you held stocks less sensitive (correlated) to oil prices, your portfolio may fare better during periods when oil prices decline, likely reducing portfolio volatility over time.
Importantly, the benefit of diversification has its limits. There is a certain point beyond which an investor’s portfolio can be over-diversified, where the marginal benefit of investing in additional securities in different areas of the market might not be worth it.
Hidden Risks of Overdiversification
Too much of a good thing can sometimes lead to poor outcomes. Being over-diversified is a common issue among investors who hold many funds. For instance, if you own 10 mutual funds, and each mutual fund holds 300 stocks, you may hold as many as 3,000 stocks without realizing it. This situation can cause inefficiencies in your investment strategy. Here are just a few notable potential issues.
Inability to Outperform (Or Even Perform As Well As) The Market
Owning thousands of stocks, like the previous example, could mean investing in nearly every security in a given market. Exposure to so many stocks can make even matching the overall market difficult, especially after accounting for fund fees.
Lack of Personalization
Many funds follow strict mandates, investing in specific market categories or styles. These kind of mandates don’t account for your personal long-term investing goals or adjust to changing market conditions. The lack of flexibility to tailor to your strategy to suit your needs could potentially hinder your ability to achieve your long-term financial goals. A tailored strategy can account for changes in your life, such as unplanned financial obligations.
Overconcentration of Stock Holdings
Many fund investors own more than one mutual fund, but these funds may have overlapping holdings. Suppose you own two or three US Technology mutual funds. It’s likely these funds’ holdings may overlap, causing your portfolio to be over-concentrated in that sector and potentially in a handful of stocks held by each fund.
Conflicting Decisions Between Fund Managers
Suppose you own two mutual funds run by different managers. In one fund, the manager decides to buy stocks in Country A as they feel this security may perform well. Meanwhile, in the other fund, the manager decides to sell Country A’s stock holdings because they believe this security will perform poorly. Both funds incur transaction costs—and potentially capital gains taxes—while you ultimately may end up with little-to-no change in your portfolio holdings.
A More Efficient Solution
Mutual funds simply aren’t a universal solution to attain diversification in a retirement portfolio. They can be an effective solution for some investors with relatively smaller portfolios who might find it challenging to build a diversified strategy through outright stock ownership. However, once you’ve accumulated sufficient funds, we believe it’s more advantageous to build a properly diversified strategy by investing directly in stocks or bonds. Direct security ownership can help you:
- Personalize an investment strategy that is specific to your individual needs and allows for a flexible approach to navigate changing market conditions
- Mitigate tax inefficiencies associated with fund turnover and better control management fees
- Reduce the risk of overconcentration in a given sector and allows for a more transparent investment management process
Fisher Investments can provide the counsel, research and analysis you need to have confidence when investing for retirement. To learn more about funds and how we may be able to provide a solution tailored to your needs, contact us or download our guide the 6 Pitfalls of Funds.