5 Common Diversification Mistakes

Investors often have a lot to consider. But few investment decisions matter more than asset allocation. A well diversified portfolio is as important for millennials as it is for retirees. Ideally you want to create a diversified portfolio so you don’t have all your money sitting in one type of asset.

This is because when one investment underperforms, it won’t necessarily affect others. So if you have your investments spread across a wide range of asset types, then you reduce the risk to your portfolio overall. For example, holding a basket of stocks will reduce volatility and risk compared to holding only one or two stocks. Furthermore, holding a basket of different types of investments will likely create more stable returns over time than only investing in one asset type.

The time span between 2000 to 2009 is sometimes referred to as the “lost decade” because investors who only had investments in the stock market most likely didn’t make any money since the S&P 500 index returned negative 9.1% during this time. However, a diversified portfolio that held other asset classes and in different parts of the world would have most likely gone up in value.

Diversification Works

5 Common Diversification Mistakes Made by Investors

A popular belief is that younger individuals should invest more in equities (stocks) and older people should buy more bonds. Some like to use the “100 minus your age” rule to determine asset allocation. Start with the number 100 and subtract your age. The resulting figure is the percentage you should allocate to equities, and the rest should be invested in bonds. For example a 40 year old index investor could hold the following two low-cost funds in the proportions outlined below.

60%: Vanguard Total World Stock Index Fund Investor Shares (VTWSX)
40%: Vanguard Total Bond Market ETF (BND)

This simple method for deciding one’s asset allocation should create long term growth for the investor, while providing fixed income stability. While it’s not a bad place to start for beginners, there are more factors to consider when creating a truly diversified portfolio. Below are some common mistakes many investors make about diversification and how to avoid them.

1. Being too diversified or not diversified enough.

Not holding enough companies can hurt an investor’s stock portfolio. This is especially true if a disproportional amount of the stocks are within the same sector or industry. For example, nearly all energy stocks took a dive in 2014 when the price of oil plummeted from over $100/barrel to roughly $55/barrel. Being overly concentrated in one area of the stock market increases one’s portfolio risk.

Mutual funds and ETFs can be used to avoid this problem because these types of funds hold many different individual stocks within them. But for investors who like to choose individual stocks, the optimal number to own for a well diversified equity portfolio is 20 names or more in various sectors. For those who don’t have time to research individual companies, services such as Betterment provide investment advice and diversified, fully automated investment management to customers for less than the typical cost of a traditional financial adviser.

At the same time, it’s also possible to be overly diversified. This usually happens when someone invests in the same or very similar stocks in different accounts. There’s also no point buying similar mutual funds or ETFs. So if there are two similar stocks or funds, investors should just pick one to invest in.