If you’re looking forward to traveling again and making up for lost time, you’re not alone. Let’s say your goal is to visit as many destinations as possible. It probably doesn’t make sense to book seven different flights to Miami with several airlines, with similar departure times, and similar arrival times. Does booking more flights translate to more destinations explored? Usually, but not if all of the flights are for the same destination at the same time. Obviously, most people wouldn’t book unnecessary, additional fights. The same logic becomes far less obvious when applied to one’s investment portfolio.
In finance, we’re frequently told to diversify, diversify, diversify. Diversification is the strategy of reducing risk by spreading out investments over different securities, investment sectors, and other categories. By spreading out investments, an investor can minimize the adverse impact of any one event. Diversification does not eliminate all risk and does not guarantee against loss of principal. Some types of risk, such as systematic risk (collapse of a financial system), cannot be reduced by diversification. However, diversification remains an important tool to limit the risks associated with being overly concentrated in one area.
This all sounds great in theory but, diversifying one’s portfolio can prove deceptively difficult in practice. An investor can easily fall into a false sense of diversification, simply because they own many different mutual funds, exchange traded funds (ETFs), and individual stocks. Similarly, booking more flights does not necessarily result in more destinations explored. Owning more securities doesn’t necessarily result in a more diversified investment portfolio.
If an investor buys a mix of S&P 500 index funds and U.S. Large Cap actively-managed mutual funds, the same stocks likely show up in all or most of the funds. Index funds are nearly identical to other funds that track the same index. Actively managed funds can differ quite a bit from one another but, can easily share common holdings depending on sector and purpose of the fund among other items. If an investor isn’t careful, they may feel diversified across many funds, even though their investment performance depends on a smaller than realized number of stocks. Evaluating one’s portfolio for overlap is crucial to successfully diversifying an investment allocation.
Whether you are a “Do-It-Yourself” investment manager or you work with a professional, ask yourself: Are you diversified or are you just buying a bunch of airline tickets to the same place?