“Diversification is the most effective form of risk management, and every decision must be consistent with maintaining a high degree of diversification—or minimal covariance—throughout the portfolio,” said Peter L. Bernstein in his book “Capital Ideas Evolving.”
In evaluating client portfolios, advisors should be alert to identify and fix diversification problems that arise. Here’s three common trouble spots.
Investment portfolios that lack broad exposure to the five major asset classes—stocks, bonds, commodities, real estate and cash—are not completely diversified. Some investors will purposely exclude major asset classes based upon personal preferences or historical performance data. This exacerbates diversification problems.
Also, the funds clients own in their core portfolios should be accurate proxies of the asset classes where they are investing. In other words, those funds should aim to replicate the performance of the asset class versus trying to outperform it.