Despite what many Wall Street firms and advisers may suggest, you don't need to stock your portfolio with an ever-expanding array of funds and ETFs to navigate today's global financial markets. In fact, such a portfolio may do more harm than good. Here's how to tell whether you're diversifying or di-worse-ifying.
It doesn't take a lot to reap the benefits of diversification. Over the 20 years to the end of June, for example, a simple mix of 55% U.S. stocks, 10% foreign developed-country shares, 5% emerging markets stocks and 30% U.S. bonds gained an annualized 8.7%, and lost roughly 27% in the crash year of 2008, according to Morningstar. Had you broadened that portfolio to include international bonds, REITs, commodities and hedge funds, it would have returned 8.6% and lost about 25% in 2008. Basically a wash.
The results could be different over other periods. But the point is that once you own a diversified blend of low-cost funds or ETFs that include U.S. stocks and bonds and foreign shares, you should think long and hard before taking on more investments.
Unfortunately, many investors can't seem to resist loading up on every Next Big Thing investment that comes along. How can you tell whether your portfolio is an example of prudent diversification or imprudent di-worse-ification? Answer these five questions:
1. Do you need the fingers of both hands to count your investments? There's no official "correct" number of investments you should own. But once you get beyond five or six, chances are you've got a lot of overlap or you're venturing into arcane investments you don't need. Truth is, you can get pretty much all the domestic and foreign diversification you need with just three index funds: a total U.S. stock market fund, a total U.S. bond market fund and a total international stock fund. You can see whether you suffer from "investment overlap"—i.e., you own the same securities multiple times in different investments—by going to the Portfolio Manager tool in RealDealRetirement's Retirement Toolbox.
2. Do you own investments you don't really understand? I don't mean having a vague understanding, as in "Oh yes, it's a leveraged ETF that gives you twice the return of the S&P 500," or "I own a variable annuity that returns a guaranteed 7% a year." I'm talking about really knowing how that leveraged return is calculated (which has big implications for what it will return) and what that 7% guarantee is actually being applied to. If you don't know how an investment actually works, then you can't know whether you truly need it.
3. Can you explain exactly why you bought each investment you own? Because it was mentioned on a cable TV investment program or appeared on some publication's Top 10 list isn't an acceptable answer. In addition to knowing how an investment works, you need to understand what specific role it plays in your portfolio and how, precisely, it improves your portfolio's performance. Ideally, you should also be able to quantify the benefit you receive from owning it by citing research or pointing to performance figures that demonstrate how it enhances the tradeoff between risk and return.
4. Do you own investments that you've never touched after buying? If you're following a long-term investing strategy, then the mix of assets in your portfolio—50% in large-company stocks, 10% in small, 40% in bonds, whatever—should reflect your investment goals and risk tolerance. As different investments earn different returns, you must periodically rebalance your portfolio to restore it to its proper proportions. To do that, you sell some shares of the winners and plow the proceeds into laggards and/or put new cash into investments that earned lower returns. But if you have investments you've never pulled money from or added money to, that suggests they're not part of this rebalancing process, and thus not really an integral part of your investing strategy.
5. Do you regularly add new investments to your portfolio? If you do, you're probably di-worse-ifying. Once you've created a well-balanced portfolio, your investing work is pretty much finished. Sure, there's monitoring and rebalancing, and maybe jettisoning the occasional dud and replacing it with a new version of the same investment (a situation you can largely avoid if you stick to index funds). But you don't need to constantly add new asset classes or investments just because investment firms keep bringing them out. In fact, if you do, you're more likely to end up with an unwieldy hodgepodge of investments that's difficult to manage rather than a simpler portfolio that more efficiently balances risk and return.
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