Most of us have heard about the virtues of portfolio diversification. What does it mean? The truth is that it means many things and most retail investors portfolio’s are not diversified even if they think it is. Below are common diversification mistakes made by typical DIY investors.

Not diversifying your portfolio into value and growth components – The most sophisticated endowment funds, foundations and defined benefit plan all split up their equity investments according to market capitalization and styles (growth and value and core). Why? Simply studies have found that growth and value both have their days of glory. In some years, growth outperforms and in others value outperforms. The key is to split your equity portfolio equally among value, growth and core components and rebalance them.

Not Diversifying by Market Capitalization – The second error we make is not diversifying by market capitalization. But this is simply because most people do not even know the composition of the stock market and the definition of large, mid and small cap. Broadly speaking, if we do by the Russell Index, the Russell 1000 index which is the large cap component in the Russell 3000 Index makes up about 80% of the Russell 3000. That means the Russell 2000 index makes up about 20% of the market cap. The Russell 2000 is actually the small cap index. Mid Cap account for about 27% of the index (mid caps are found in both the Russell 1000 and 2000 index). A well constructed portfolio should have at least 70-80% in large cap, split between core, value and growth, and about 20-30% in mid and small caps (split among core, value and growth as well).

Not diversifying among funds – Yes, if you invest all in one fund family, you may get discounts and breakpoints on sales loads. But by doing so, you are not diversifying among different managers and fund family. Most fund families are only strong in certain areas. It is the nature of the business. No one fund family dominates every sector. Using only one fund family will almost certainly bring down your returns versus using best of breed funds.

Not diversifying Internationally – While the smartest endowments, foundations routinely have 20% to 40% of their equity portfolio in international equities, most retail investors have only about 5%. This is despite the fact that international equities makes up slightly over half of the total global equity market capitalization and it is expected to make up 75% in years to come. So the result is that most retail investors are only now pouring money into this sector now that it has been on fire. So rather than trying to time the market, get the allocation right from the start.

Not diversifying among international funds – While some retail investors will take the time properly diversify by market capitalization and styles in their domestic equity portfolio, they simply just buy one fund for their international equities. That is another common mistake. Like the domestic market, 80% of the international market is made up of large cap stocks. So you should be looking for a large core, value and growth international fund and supplement that with a mid/small cap value and growth fund.

Not Diversifying among fixed income investments – This is another common mistake. This stems from not understanding the compostion that makes up the aggregate fixed income market – like about 37% is in mortgages, 27% is in corporates. Find out what the composition is in the Lehman Brothers Index and make sure your bond funds have a similar composition. However, if you look into the best performing morningstar funds, most bond funds have their portfolios skewed towards having too much corporates or mortgages. The best solution is to seek a government and a corporate bond fund.

Not Diversifying Beyond Traditional Fixed Income – Just like international equities, most retail investors do not diversify beyond domestic fixed income. But there is more foreign debt than there is US debt. The most sophisticated investors like endowment funds have a name called “enhanced fixed income” as a seperate asset class. This consist of international fixed income, high yield debt and emerging market debt. To enhance diversification in your fixed income portfolio, make sure you have funds in these sectors as well.

Not using any index funds or ETFs – Yes, even sophisticated investors (like the endowments, foundations and define benefit plans) use indexing. Not for their whole portfolio, but for a portion of it. For the retail investors, indexing can be used when you cannot find a good manager to fill in a style box. For example, it is more difficult to find a good mid or small cap manager or fund. The good ones close their funds once they reach a certain size. In this case, indexing is a good solution.

Indexing Your Whole Portfolio – While some do not index, many retail investors take the extreme end and index everything. There is enough debate about the merits and demerits of indexing. But the truth is while indexing has a place in your portfolio, just indexing your entire portfolio restricts you in how you can enhance your portfolio. By simply indexing, you accept market risk. By varying your debt and equity allocation with indexing, you can only lower your risk by reducing your expected return and vice versa. Having active managers allows you to potentially enhance your portfolio by having better risk adjusted return. What do I mean? If you can find a manager who history has just matched the index, but with less volatility in the portfolio, you would be ahead investing with this manager rather than the index because in bear markets, this manager will outperform the index and though expected return (or average return over the long run) is identical, the active portfolio will come out ahead because it is less volatile.

This is also the real reason for diversification – to move up the “efficient frontier” and improve your risk adjusted return.

Not investing in REITs, Natural Resources Stocks and Alternative Assets – OK, not all of us are wealthy enough to have access to hedge funds and private equity. But we can all invest in REITs and natural resource stocks. These assets are much less correlated with the equity markets and really should have a place in your portfolio. 5% in REITs and 5% in natural resources would be good starting points.

Parting Words: Make sure you use the right index to measure your fund’s performance

If you truly want to diversify your portfolio, you may end up with probably 15 funds. Is that too much? Definitely NO. The largest money managers and asset allocators have hundreds of funds. Yes, we are retail investors, but if we really practice diversification, having 15 or more funds should not be an issue. It will be an issue because you may end up having 15 statements from 15 fund families and you will have a hard time rebalancing. One solution is to hire a financial advisor and use a wrap program where you pay a fee based on asset size. You will get just one statement and automatic rebalancing. (BTW – rebalancing reduces portfolio volatility).

Another thing to be aware of is that you have to use the right index to measure a fund’s performance. For example, you cannot compare a large cap growth fund to the S&P Index. The proper index to use is the Russell 1000 growth index. Similarly, a large cap value index has to be measured against a Russell 1000 value index. The reason why the mainstream media says more than 90% of actively managed funds funds fail to “beat the market” is simply because they should not be using the market index. Small cap managers should be measure against the small cap index, and not the S&P. If you measure funds against the proper index, the figure is much less than what the mainstream press and “finance celebrities” have you to believe. Check out my post on comning active and passive investing for details.

This entry was posted on Saturday, May 26th, 2007 at 03:19 and is filed under News. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.