Diversification and Portfolio Overlap

Diversifying is easier said than done. It’s easy to own stocks across different market sectors, such as a tech company and an oil company and a clothing company plus a food company. But there are more layers to diversification. You should diversify in terms of size and geography, in addition to market sector.

If you own mutual fund shares, assessing your diversification can involve some work, because the true scope of your investments is hidden. By drilling down into the funds you are invested in, we will learn how many funds hold the same stocks. We call this Portfolio Overlap. That redundancy can reduce your true diversification and add complexity to managing your investments.

Asset allocation and diversification are the most important factors in a portfolio’s long-term performance. Most people know that diversification is important and believe that their portfolio is diversified. In reality, most people fall far short of achieving true portfolio diversification. Even people invested in one or more mutual funds often hold fewer than 4,000 unique stock or bonds in their portfolios, yet wrongly believe they are well diversified. In the modern financial world, many mutual funds hold over 10,000 different stocks. (The one I currently favor holds over 12,000.) More importantly, while a wide spread of stocks is important, the total number of unique holdings alone doesn’t actually tell you anything about how diverse those assets are. They could all be in foreign banks or fast food companies for all we know.

When we meet to conduct a Portfolio MRI on your investments, we will break down your asset allocations in detail, and make sure the mix meets your investment objectives. Then, using indices for different investment categories, we will compare the performance of your portfolio’s asset mix to the historical performance of other mixes. That way we can make sure you are truly and properly diversified.