The Wrong Way to Diversify

In the following video, author Jack Schwager gives some excellent advice on the meaning of true diversification to allay some investment risk. Another way to complement your risk hedging strategy is with strong dividend stocks. If you're interested in some of these dividends on your quest for high-yielding stocks, The Motley Fool has compiled a special free report outlining our nine top dependable dividend-paying stocks. It's called "Secure Your Future With 9 Rock-Solid Dividend Stocks." You can access your copy today at no cost! Just click here to discover the winners we've picked.

Brendan Byrnes: What do you think is the best way for investors to diversify? Obviously, there are a couple different schools of thought here.

You can buy a basket of 30 stocks and you get a bunch of different stocks, different industries -- an automaker, Ford; an energy company, [ExxonMobil]; a tech company, Apple, [] -- and you just create a bunch of these different individual stocks, and then, as you mentioned, there's index funds and then there are also mutual funds, maybe with low correlations, that you could use to diversify.

What do you think is the best way to go about it? Is it, again, up to the individual investor, or do you think there -- ?

Jack Schwager: Yes, but there the main message with diversification is, what people do wrong is they think of diversification in numbers, like if you're adding more assets, you're getting more diversified. I point out that actually, if you're adding correlated things, you might actually be reducing diversification.

I use an example if you were allocating to managers. For example, if you had five managers you were allocating to, using all different approaches, then you added 10 who were using a similar approach, that 15-manager portfolio ends up doing -- even though the managers are equal quality-- it ends up doing much worse, more risk, even though you've tripled the number of managers because you just added a whole group that act like one.

You've got to pay attention to how uncorrelated your assets are, not just what the number of assets are.

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