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Is Your Portfolio Truly Diversified?

One of the basic tenets of portfolio creation is that you should diversify. This is good advice — as long as you are truly diversified.

Unfortunately, it’s too easy to misconstrue what constitutes diversity. In many cases, investors divide up their portfolios between stocks and bonds, and call it good. While this can provide some basic diversity, you might not end up with true¬†diversity.

More Than Asset Class

It’s important to understand that real diversity in your portfolio is about more than just asset class. Maybe you have a portfolio that is 70% stocks and 30% bonds. But what investments are you making with that asset allocation? Is the stock portion of your 401(k) heavily weighted with company stock [3]? If so, you could be insufficiently diversified — especially if your employer tanks.

Look beyond asset class, and get down into the meat of your portfolio. Are the stocks you have diversified across sectors and industries? Do you have a few well-chosen municipal bonds mixed in with your stolid Treasury securities? Have you considered using funds to help you add a little more diversity? What about geography? Don’t forget that sometimes a little geographic diversity can be good for your portfolio, too.

It’s true that you don’t want to water down your portfolio with too much diversification. Even so, be on the look out for areas where you might be too concentrated. Even if you have funds, look into them. Do you have multiple funds that invest in the same sectors? If so, you could be too concentrated in that one area.

Don’t think that because you are using the “age subtracted from 100 (or 120)” rule to divide your portfolio into stocks and bonds that you are covered.

Add Other Asset Classes to Your Portfolio

While many portfolios are made up, primarily, of stocks and bonds, that doesn’t mean that you shouldn’t diversify a little bit more with your asset allocation. Commodities and real estate can make good additions to your portfolio. You don’t have to make them a huge part of your portfolio if you aren’t comfortable with the prospect. I have a friend who decided to add a little more diversity to his portfolio by investing in a commodity ETF and a REIT [4]. Only about 10% of his portfolio is in these two items, but he feels better with them in the mix.

In many cases, stocks and bonds alone don’t provide the kind of diversification that you might need. Really think about your situation, and your goals. Adding a little something extra to your portfolio can help you take advantage of other trends in the market, without risking your future. Changing your asset allocation [5] up just a little bit can make a big difference later.

Keep It Simple

For some investors, simplicity is the most important thing. If you want a simple portfolio, it’s easy to build one out of low-cost ETFs [6]. These investments can help you build a truly diversified portfolio, they trade like stocks, and they won’t eat up your real returns with fees. You can find ETFs for almost every asset class, and even some that focus on specific sectors. It’s even possible to invest in ETFs that focus on foreign investments to add a spark of geographic diversity to your portfolio.

(Photo: Philip Taylor [7])