“I know my company best. I’m loading up my on company stock.”
“I own several mutual funds, so I’m really diversified.”
“I like to spread my money around with different institutions. That way, I stay diversified.”
“I watch some pundit on TV and according to his guidance I’m diversified.”
Have you ever said something like this?
In that case, I have some bad news for you: your investments may be subject to more risk than you know.
When it comes to our investments, being diversified is important, and it doesn’t have to be difficult. It does, though, require a little more effort than any of those leading statements might indicate.
What is diversification? Put simply, it’s making sure that you don’t have too much of your livelihood dependent on the outcome of any one investment.
In other words, it’s the practice of holding different types of investments that don’t always rise and fall together and that have varying degrees of risk.
The statements that lead this article are ones I hear on a regular basis, so I’d like to walk you through why each introduces undue risk.
Betting the Farm on Your Employer
The most common diversification misstep I see is employees who have most or all of their retirement savings invested in their own company’s stock. Talk about concentration risk! If you do this, not only are you reliant on your employer for your current income, but you’ve unnecessarily become reliant on that same company for your financial future as well! Even the best-run companies can face unforeseen hardships. Don’t risk your future by turning a blind eye to that possibility.
Owning “Several Funds” for Diversification’s Sake
A mutual fund is an instrument that allows investors to purchase and own a portfolio of different investments typically invested by a manager or team of managers. Why, then, is owning several different funds not a great way to provide diversification? For one, it’s not efficient. It adds costs to the equation that may not be necessary (most all mutual funds do this but that’s a story for another day). In my practice, I often have people come to me with brokerage account statements loaded with different mutual funds. I look further into the funds and find that nearly all of them have the same top holdings.
What’s the point of owning three funds if they all put their money in the same place?
Using Multiple Money Managers for Diversification’s Sake
Does keeping money with different investment firms improve your diversification? Maybe. Maybe not. What it certainly does, though, is handicap your chances of reducing risk. Does each of those managers know what you hold at the other institutions? If they don’t, then how are they to make sure you’re not over-concentrated or under-represented in any particular investment, asset class or tax style? It’s possible you could run into the same potential area of concern as with owning multiple mutual funds just for diversification’s sake—exposure to the same investments simply held at different institutions.
Listening Exclusively to Media Personalities for Investment Advice
Television pundits are entertaining. Some of them are very smart; many of them are not. None of them, however, know you and your personal financial situation. How, then, can they tell you whether you’ve done a good job of mitigating risk in your investment portfolio? I know that without meeting you I certainly couldn’t. Suppose you own a rental property and one of your largest investment holdings is also a REIT (Real Estate Investment Trust).
Just looking at your brokerage statement, it wouldn’t be apparent that you may be over-concentrated in real estate. You can’t see that through a TV camera.
So, what’s the bottom line? Be aware of these common diversification missteps so that you’re not making your portfolio riskier than it needs to be.
By John N. Hall, CFP®
Disclaimer: This article is generalized in nature and should not be considered personalized financial, legal or tax advice. All information and ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.