Diversification can reduce individual investment risk if managed well.
A common buzzword in the investment world is the concept of “diversification.” Diversification at its core is the technique of mixing a wide variety of investments within a portfolio. The rationale behind this is that when your investments are diversified, you offset the risk of any one investment performing poorly to have a broadly negative effect on your portfolio. In and of itself, this is a sound idea.
However, an aspect of diversification that is not readily spoken of is whether the individual assets themselves are appropriate for the investor. For example, a younger investor with a higher tolerance for risk being diversified with bond exposure may actually pose a higher level of risk – the bonds may pose a higher risk of lost return over longer periods of time. This keeps in mind that “loss” does not just mean losing money, but also the money that could have been earned, but was lost instead due to an inappropriate allocation. Similarly, an older client with a goal of capital preservation having exposure to a sector fund, while yes they are diversified, exposes the portfolio to risks not aligned with that client’s goals. In both cases, diversification is applied inappropriately because the investments being diversified into do not align with the goals of the client.
From my experience, there are a couple of scenarios where this has most likely occurred. One of these situations is when a bank or insurance/mutual fund company tries to sell shares of their specific mutual fund, where the recommendation only has to be “suitable” for the client. The adviser may not be taking the client’s other investments into account, or really getting to know the client well, or may just not really understand what managing risk actually means. All of these situations are perilous for the investor.
The other, and I think far more difficult to spot, are “Target date” retirement funds. These funds will typically present themselves as self-managing portfolios that adjust the risk profile of the fund over time, shifting from being heavier in equity positions early on to a more balanced selection of equity and bond/fixed income holdings as the fund holder gets closer to retirement. Sounds great in theory – the portfolio manages the risk exposure by itself, no need to worry about balancing different funds out. However, what I have found in many of these target retirement funds are 2.5 major flaws.
Flaw #1: The investment allocation is inappropriate for the client. The typical trend I see in target funds with bad allocations is that they are more conservative than is appropriate for the client. Now, that sounds good to an extent on its surface – more conservative means that there’s less of a chance of being exposed to losses. However, it also means losing exposure to gains you should have had exposure to, and missing that growth can really hurt, especially when that lost growth is compounded by more lost growth over a 20 or 30-year time horizon.
Flaw #2: The investments they use are actually just other mutual funds they own. A key problem to this approach is that those funds each have their own individual mandates and goals that may not reflect the owner of target retirement fund. So while you may have an allocation from a 36,000 ft point of view, that does not mean the strategies being used in those funds and their investments actually align with your goals.
Flaw #2.5: The investments they use are actually just other mutual funds they own AND THEY ARE GARBAGE. I have seen some rather interesting and poor-performing funds stuffed inside the structure of a Target Date fund allocation. This can be done to prop up fund strategies they are having a tough time selling on their own, making a fund look more broadly supported than it is. They can defend the decision to include it based on suitability, but that doesn’t mean any adviser would go out of their way to actually recommend the bad fund.
Diversification of investments is a sound approach to helping mitigate the risk of individual companies having an overly severe impact on the performance of a portfolio. However, diversification cannot be a mindless exercise of “putting a little on everything” akin to placing chips all over a craps table – this is a dangerous endeavor that can cause long-term damage to your returns. With careful planning, diversification is a tool that can be carefully used to manage the risk of a portfolio while maintaining alignment with your goals.
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