By Rick Waechter, Founder, and Justin May, Portfolio Manager

Most investors realize that it’s crucial to diversify – to avoid putting all your eggs in one basket. Sadly, too often, we see examples of how not to diversify. Just as sadly, often these are solutions foisted upon investors by financial advisors who have all the wrong reasons to do so.

Here are a few of the more common mistakes.

1. Owning a lot of funds that are similar. It seems logical that holding multiple funds with seemingly different strategies would increase your diversification. Holding the Blue Chip Growth Fund, the Momentum Fund, the Strategic Equity Fund, and the Intrinsic Opportunities Fund in tandem might feel sophisticated. In reality, those funds likely hold many of the same stocks, just in different proportions. So, increasing the number of funds only accomplishes two things: increasing your fees (remember, fancy fund names = fancy fees), and increasing the likelihood that your portfolio will track an index. Don’t believe us? Click this link to see a ‘fancy’ fund with 21 sub-advisors and performance identical to its benchmark index. Don’t fixate on the number of funds in your portfolio. Focus on the number of underlying stocks and bonds. You can diversify with a very small number of broad funds. And it’s a lot easier to understand what you own than a large collection of funds mashed together with an approach one might call, “everything but the kitchen sink, well, on second thought, let’s throw in the kitchen sink, too.”
2. Spreading accounts between multiple brokerage companies. There’s no good reason to have your accounts at more than one brokerage firm. If you’re using a large, established brokerage company with good technology and competitive pricing, you don’t need a second broker. Remember, the risk you’re trying to diversify is in the investments themselves, not the brokerage company. Even if the brokerage company went bankrupt, you would be protected, because you, not the brokerage company, own your investments. The downside of using more than one broker is clutter and greater difficulty managing your overall risk exposure.
3. Chasing “outperformance” within bonds. The purpose of bonds within a portfolio is to rise when stocks drop. Only high-quality bonds behave this way. The problem: over long periods of time, these bonds typically underperform their riskier peers, such as high-yield or floating rate bonds. That’s because, on average, the stock market return is positive, so risky bonds will also usually do well. But when stocks crash, a high-risk bond portfolio crashes too, and the investor discovers they weren’t as diversified as they thought.
4. Buying individual private deals, whether from your neighbor, good friend or a professional(ish) fund manager. Yes, these certainly diversify you. They will surely have a different return profile than the US stock or bond market. And yes, the upside may be better than stocks. But be careful. The average private deal is a dud. For every Jeff Bezos starting Amazon in 1994, there are thousands of zeros. The data on professionally managed venture capital and private equity is admittedly better, but it appears to be better only if you invest with experienced managers through diversified funds. And you give up access to your funds if you need them, typically for years.

If you made it this far … here’s the right way to diversify:

1. Buy a small number of low-cost, broadly diversified ETFs or mutual funds, owning every stock in the world and a representative sample of the US or global bond market. All the largest fund managers offer these funds.
2. Figure out how much risk you can take (stocks) and how much cushion you need (bonds). Once you’ve decided on that mix, stick to it, unless your personal situation changes. Don’t change the mix just because the market changes.
3. If you want to dip your toe into alternative investments, make sure you can wait out the typical 10+ year holding periods, and use managers with a solid, long-term track record who manage funds with 100+ deals.
4. If you want to dabble in an “off the wall” investment your neighbor has recommended, fine … as long as you don’t dump much money into it and you understand it’s the equivalent of a trip to a casino. It’s entertainment, but not likely to make money.