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Effective Diversification

William J. (Bill) Lynott |

CHICAGO — If there is one investment philosophy that approaches universal agreement among financial advisers, it’s the need for careful diversification in every portfolio in order to minimize risk, but exactly what does diversification mean, and how can you tell if your investments are truly diversified?

One popular TV show on finances features a segment called “Am I Diversified?” in which viewers call in, give the host their top five holdings and the host lets them know if they are properly diversified. According to Jason Whitby, MBA, CFA®, CFP®, AIFA®, senior financial adviser with Miami-based Investor Solutions, it’s not that simple. “The idea of five-stock diversification is mostly refuted by the financial community,” he says, “which tends to agree that the number of individual stocks needed for diversification is actually closer to 30.”

So, where did the number 30 come from? According to Whitby, it was probably the result of a 1965 study by analysts Fisher and Loire. “From this study came the mythical legend that 95% of the benefit of diversification is captured with a 30-stock portfolio,” he says. “While 30 is no doubt better than five, it just isn't good enough.”

A later study by Sur and Price would seem to support Whitby’s conclusions by suggesting that even a portfolio of 60 stocks captures only 86% of the diversification of the market in question.

Obviously, effective diversification is not as simple as it may seem on the surface. So how do you go about ensuring that your portfolio is truly diversified?

According to Whitby, to be properly diversified in a way that will adequately capture the market’s returns and reduce risk, you must capture the entire global market, including:

  • Domestic Growth Small Companies
  • Domestic Value Small Companies
  • Domestic Growth Large Companies
  • Domestic Value Large Companies
  • Foreign Growth Small Companies
  • Foreign Value Small Companies
  • Foreign Growth Large Companies
  • Foreign Value Large Companies
  • Emerging Market Companies

Further, he says, you must capture the entire industry diversification within each of these markets:

  • Telecom services
  • Utilities
  • Energy
  • Consumer staples
  • Healthcare
  • Materials
  • Information technology
  • Financials
  • Consumer discretionary
  • Industrials

Wow! If Whitby is correct in his assumptions, it would seem obvious that individual investors attempting to properly diversify their portfolios by selecting individual stocks, whether in the entire global market or just the U.S. market, have little or no chance of succeeding. Among the difficulties to consider in that approach, he cites:

  • whether your portfolio is large enough to have a meaningful position size in each category.
  • having so many stocks to trade would increase trading cost.
  • administrative record-keeping and statements would be overwhelming.
  • such a portfolio would be extremely difficult, time-consuming and expensive to research and manage.

“Too often, people end up with a collection of somewhat random investments,” says Whitby. “The individual choices may be fine, but as a whole provide only the illusion of diversification. Proper global diversification requires a careful allocation of multiple asset classes and styles. For the vast majority of investors, the only practical and cost-effective way to achieve true diversification is through broad-based, no-load index mutual funds and exchange-traded funds.”

Whitby emphasizes that it’s important to stick with index funds—that is, funds that attempt to track one of the standard stock market indexes such as the Dow Jones Industrials or the Standard & Poor’s 500 index.

Equally important, you should stay away from mutual funds that have a sales charge called a “load.” The load may be imposed as a sales charge when you buy the fund or as a redemption charge imposed when you sell the fund. Either way, you will be paying a fee that contributes nothing to the likelihood of successful performance. Always make certain that the mutual fund you are buying is a “no-load” fund. Past studies have shown that load funds have no performance advantage over no-load funds.

If you decide to invest in the increasingly popular exchange-traded funds (ETFs), you’ll pay the same sales commission as stocks. However, their passive management results in low management fees, which tend to offset the sales commissions. Another advantage of ETFs is that you buy and sell them just like stocks, with posted price changes during the trading day. Thus, you know the exact details of your transaction as soon as the trade is completed. When you buy or sell a regular mutual fund, you must wait until the following day to get that information.

Whether you decide on index mutual funds or ETFs, you’ll have a wide choice. There are now more mutual funds/ETFs than stocks from which to choose.

Always keep in mind, though, that any investment in equities, whether in individual stocks, mutual funds or ETFs, carries risk. If the price of equities contained in a given fund goes down, the value shares in the fund will go down as well.

While there is no way to eliminate risk in any form of stock market investment, financial advisers agree that proper diversification is the key to minimizing that risk.

Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax adviser for advice regarding your particular situation.

About the author

William J. (Bill) Lynott

Freelance Writer

William J. (Bill) Lynott is a freelance writer whose work appears regularly in leading trade publications and newspapers, as well as consumer magazines including Reader’s Digest and Family Circle. You can reach Lynott at blynott@comcast.net.

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