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How to Solve Diversification Problems

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“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.

Under-Diversification

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.

Over-Diversification

Owning too much of the same type of investments is a common problem. For example, an investor may hold several large cap U.S. stock funds in the same portfolio.

Although each fund may have a unique investment strategy, owning multiple funds that invest in the same asset class could produce unnecessary duplication or over-diversification without any long-term benefits. Explain to your customers and prospects that it makes little sense to be over-diversified in the same types of investments.

Uneven Diversification

At times, an investment portfolio will suffer from both under- and over-diversification. An investor, for instance, may own four mid cap stock funds (over-diversification) while simultaneously missing portfolio exposure (under-diversification) to bonds and real estate. What is this called? I refer to this condition as “uneven diversification” and it can add unwanted portfolio risk and underperformance.

A properly diversified portfolio won’t completely eliminate market risk. However, spreading your money across a variety of distinctly different asset classes should help to mitigate the inevitable uncertainties and risk that will come in the future. In other words, diversification is a simple and affordable way to hedge.