investment diversification

Do You Have A Diversified Investment Portfolio? What Else Should You Consider?

Does the term “investment diversification” make you want to skip this read?  If so, all the more reason to continue! The diversification inherent in your investment portfolio heavily impacts your retirement goals.

The technical answer on why pursuing a diversified portfolio is important: to improve your investment portfolio’s risk-adjusted return.  Whether you work with a financial advisor or not, you’re often guided into a few misconceptions related to this topic, which I’ll highlight here.

Consider a portfolio’s diversification from two angles: amongst asset classes (i.e., equity, fixed income, alternatives, cash) and within asset categories.  Examples include, but are not limited to:

  • Equity: US (Large, Mid, Small Market Cap), International (excludes the US), Global (includes the US), Emerging Markets
    • Don’t forget about characteristics such as Growth vs. Value.
  • Fixed Income: Corporates, Governments, Asset-Backed, High-Yield, Convertibles, Municipals, Bank Loans, Preferreds
    • Don’t forget about characteristics such as Duration (i.e., Short, Intermediate, Long-Term)
  • Alternatives: Real Estate, Commodities, Long/Short Strategies, Managed Futures, Options-Based, Market Neutral
What Do I Use?

I use Mutual Funds and ETFs in my model portfolios, which own a collection of individual positions in a particular category.  These products charge a fee, which is not typically transparent to the retail investor.  Let’s touch on a couple of these topics in more detail.

Collection of Individual Positions

Just because a fund owns a basket of securities does not necessarily mean it’s “diversified.”  What if you own just two mutual funds, for example, and there is significant overlap in the underlying securities?  That defeats this exercise’s purpose, and now you’re paying twice for the same position.  Awesome.

What if you add 20 more mutual funds or ETFs to help mitigate this?  Well, then the benefits of diversification start to diminish once you hit the 20 to 30 securities mark, according to E.J. Elton and M.J. Gruber, two academics and the authors of Modern Portfolio Theory and Investment Analysis.  It’s like dark chocolate (replace as necessary) – the first few bites are great but eating the whole bar may not offer the same utility.

Internal Expense Ratio

This is the management fee that the mutual fund or ETF manager charges to run their portfolio.  They are listed in the prospectus and on research tools, but not on your statement. This fee is deducted from the portfolios return and is in addition to what your advisor charges.  “Active” funds have higher expense ratios than “passive” funds, which mirror an index.

The industry’s average internal expense ratio in their model portfolios is between 60-80 basis points or 0.60%-0.80%, but it can be north of 1%.  A purely passive portfolio might fall somewhere between 10-20 basis points.  My model portfolios fall in the middle at 30-40 basis points.

Other Factors to Consider
  • Time Horizon & Risk Tolerance – The more time you have, the more risk you are likely able to withstand, assuming you don’t make tactical changes in your portfolio.
  • Correlation – This measures the degree to which two investments move in relation to each other. Don’t just add exposure to a position because you don’t have it.  If it behaves in unison with another one you already have (i.e., it is highly correlated), it won’t help to diversify your portfolio.
  • Asset Location – This is the allocation you have amongst three tax buckets: taxable, tax-deferred, and tax-free. The goal here is to be well diversified in this regard as well.
  • Tax Sensitivity – I load up on municipal bonds, qualified dividends, ETFs, and low turnover funds in a taxable account to reduce tax drag.
  • Rebalancing – I rebalance my client’s portfolio once or twice a year. If you do this too often, you generate unnecessary turnover and potentially transaction fees that drag down the portfolio’s performance.
  • Tax-Loss Harvesting – I do this in December each year for my client’s taxable accounts to make sure we are taking advantage of capital losses to offset capital gains elsewhere in the portfolio, thereby maximining your tax alpha.
Please remember…

Just because you are diversified does not guarantee you are immune from loss, as the risk is never 100% eliminated. What if something catastrophic happens to one sector of the market? This is the purpose of investment diversification – to have a range of exposure across varying sectors. In this way, the other parts of your portfolio are safeguarded from the same magnitude in volatility. Had you moved to cash on March 23, 2020, and are yet to go back in as of late October 2020, you missed out on a 50%+ rally in the S&P 500.  This is where having someone else manage your investments is critical – to take the emotion out of it! 

If you’d like to hear more about my investment philosophy, let’s get some time on the calendar.