Many investors see a diverse portfolio as the perfect solution to the perils that the stock market holds. If you're not careful, though, your attempts at diversifying your holdings might well increase your risk, rather than decreasing it.
A grand experiment
Investors often think that diversification simply involves adding more stocks to their portfolios. They figure that if they own just one stock, it's vulnerable to a complete meltdown if something happens to that company. If they own several stocks, however, the odds of all of them coming crashing down at exactly the same time are fairly low.
Intuitively, that logic makes sense. But as a recent Wall Street Journal article discussed, a study by a Louisiana State University finance professor showed just how difficult it is to build a low-risk diversified portfolio. The study found that on average, a 20-stock portfolio had 40% lower fluctuations than a single-stock selection. Yet for nearly a quarter of the students, the 30-stock portfolio they chose was actually riskier than simply holding a concentrated portfolio of the first five stocks they picked.
Why adding stocks doesn't work all the time
How could that happen? There are a number of reasons why adding investments doesn't necessarily decrease risk:
- If you like the prospects for a given industry, you tend to pick stocks related to it. For instance, if you own ExxonMobil
(NYSE:XOM) , adding shares of BP(NYSE:BP) and ConocoPhillips(NYSE:COP) doesn't give you any additional protection from the primary risk they all share: When energy prices fall, those stocks will likely drop in tandem. - As investors learned in last year's bear market, many different types of assets have returns that are highly correlated with each other. For instance, given the strong link between real estate and commercial banks, you should expect to see REITs and other real-estate investments move closely with bank stocks like Bank of America
(NYSE:BAC) and Wells Fargo(NYSE:WFC) . As a result, REITs won't provide the same diversification to a financial-heavy portfolio that they would for an investor holding a lot of stocks in different sectors. - The first stocks chosen by students in the LSU study were typically well-known blue-chip stocks like Starbucks
(NASDAQ:SBUX) and Nike(NYSE:NKE) . Once you start running out of obvious ideas, though, you're more likely to pick small niche stocks that are much more volatile. Those tiny companies might boost your overall returns, but they'll also bring wider swings to your investments overall.
Even mutual fund shareholders don't always get the diversification they expect. Although most funds hold anywhere from 25 to several hundred different stocks, you have to be careful not to buy funds that hold similar types of stocks. Otherwise, you could easily end up with funds whose holdings overlap extensively, giving you next to no extra benefit.
Diversify smarter
So if there are so many ways to goof up diversification, what's the best way to get it right? Looking at index funds can give you some perspective. In particular, even if you want to buy individual stocks rather than a fund, ask the following questions:
- How do your allocations to given sectors of the economy compare with a U.S. total stock market index fund? That can reveal concentrated bets in particular industries; that may be what you want, as long as you're comfortable with a non-diversified portfolio.
- In addition, what does your breakdown among different sizes of companies look like? If it's markedly different from that total stock market fund, then be sure that the position you're taking reflects your beliefs about how large-caps will perform relative to small-caps.
- Similarly, for international investors, how do your allocations to stocks of particular countries compare to a world stock index? Following an index ensures geographical diversification.
There's no rule that says you have to mirror an index. Many of the greatest investors in history have made concentrated bets in areas they believe will pay off the most. But if diversification is your top priority, deviating too much from an index may not be the move you want to make.
Diversification can reduce risk -- but only if you're smart about it. Rather than just adding new stocks to your portfolio, study how a new stock pick will fit into your overall portfolio. You'll be amazed at the difference it makes.