The Illusion Of Diversification
Don’t put all your eggs in one basket. I have no idea where that idiom originated from, but it is perhaps the best and simplest way to describe diversification.
Instinctively investors know they should diversify their portfolio and most do this. Having looked at hundreds, if not thousands, of portfolios, I can tell you that diversification amounts to more than just owning multiple funds.
A common mistake that investors make when trying to diversify their IRA or 401k is that they, inadvertently, create a portfolio that has the illusion of diversification. Let me explain. Most investors use mutual funds or ETFs to diversify their portfolios. There is absolutely nothing wrong with that approach. Each mutual fund and ETF will have a stated investment strategy. When you combine different funds in a portfolio you aim to diversify the portfolio. However, if each fund you add owns the same stocks or bonds, your portfolio is not diversified; it merely has the illusion of diversification.
There are thousands of mutual funds, and many share similar investment strategies. One of the most common strategies is to simply invest in U.S. Large Cap Stocks. Far too often in my career, I have witnessed a portfolio with eight or more funds all investing in the same U.S. Large Cap Stocks. Below is a stock intersection report. It shows what a portfolio that has a large number of funds investing in the same stocks might look like:
Source: Morningstar Advisor Workstation
As you can see, the hypothetical portfolio has eight funds from eight different fund companies. I know for a fact that some of these fund companies have dramatically different investment views, yet they are all buying the same stocks. Although I have included only a small sample, the stock intersection report on this portfolio continues for nine pages.
This portfolio is clearly suffering from a case of diversification illusion. As further evidence, here is the portfolio asset allocation and “style box”:
Source: Morningstar Advisor Workstation
As you can see, the portfolio is invested almost exclusively in U.S. stocks with a very heavy majority of those stocks being in the large cap growth category.
There is nothing wrong with large cap growth as an asset class, nor is there anything wrong with having a portfolio that tilts toward the U.S. The problem occurs when there is so much overlap between funds that although diversification is the goal, it is not accomplished. We believe at FSG that investors are best served by investing portfolios with a more balanced approach. We like to see that the style box contains stocks of different sizes and factors. An asset allocation pie chart should contain both U.S. and Non-U.S. Stocks and it should tilt towards an investor’s desired risk. We do not know what the immediate future holds, but we do know that over time, truly diversified portfolios reduce risk and may help returns.
Written by Brice Carter
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