Unless you’re brand new to investing, you’ve probably heard a lot about diversification.
It’s good practice to diversify across asset classes to help manage your portfolio risk.
In other words, spread your money across different investment categories (asset classes) to avoid putting all your eggs in one basket.
Here’s a common scenario: Jenny goes to visit an investment advisor. One of the first steps the investment advisor takes is to conduct a risk assessment. This determines Jenny’s risk level and the optimal asset allocation. In the next step, the advisor will recommend a model portfolio, featuring a generic pie chart of target asset allocations. From there, Jenny fills in each piece of the pie to achieve the recommended breakdown.
But there’s more to it than just this.
Diversification is more complex than just filling in the various pieces of a pie chart.
The next time your broker or advisor claims that investing is 90% about asset allocation, challenge that thinking. Having a mix of asset classes is important — but so is appropriate investment selection, especially when it comes to considering the impact of fees, manager performances, and taxes.
The two-step approach Jenny’s advisor followed ignores the actual funds you can choose from. It also assumes that funds can be categorized into single-asset classes, which is rarely the case. This method treats the asset allocation decision as more important than the investment selection decision. But investment costs, the quality of the investment options, and restrictions on the types of investments you hold can have a big impact on the most appropriate strategy for diversification.
Many advisors are aware of these issues and check the cost and quality of fund options to help make sure clients are building their portfolios with funds that are appropriate for their situation. However, as a smart investor, avoid being steered toward overpriced funds just to complete your target asset allocation. Instead, confirm whether the funds would actually improve the overall risk and return of the portfolio.
A recent study found that “by a wide margin, decisions around personal finances are the ones people second guess the most.”1 That’s not surprising given the complexities involved and often ill-advised approaches to financial decisions. Even while diversification doesn’t always ensure that a portfolio won’t lose value, it’s an important aspect of investing strategy. If you find yourself second-guessing your portfolio diversification, contact an advisor in your area for help beyond the pie chart.
This post is based on Chapter 8 from the book, The Intelligent Portfolio, by Christopher Jones, Financial Engines’ chief investment officer. The content has been revised for the purposes of this blog.
1 Finances in Retirement: New Challenges, New Solutions. Merrill Lynch Retirement Study, conducted in partnership with Age Wave. Retrieved March 7, 2017, from https://mlaem.fs.ml.com/content/dam/ML/Articles/pdf/ML_Finance-Study-Report_2017.pdf