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The Full-Meal Deal of Diversification

Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law.

In our last few blogs, we have explored the formidable odds that both amateur and professional investors face in trying to outsmart the market, with its lightning-fast price-setting efficiencies.

Today we turn our attention to the many ways you can harness the power of the markets to work for you. Among your most important tools in this regard is diversification. No other single action can match it in helping you to simultaneously lower investment risks and potentially improve your returns.

While they may seem almost magical, the powers of diversification have been well documented and widely explained by academic research spanning some 60 years.

What is diversification? In a general sense, it refers to spreading your risks around. In investing, it means more than just having many holdings; it's also about having many different kinds of holdings.

To use the old adage about not putting all your eggs in one basket, we're talking about having multiple baskets, containing not only eggs but also a bounty of fruits, vegetables, grains, meats and cheese.

This may make intuitive sense, but many investors come to us believing they are well diversified when they are not. They may own a large number of stocks or stock funds across numerous accounts. But upon close analysis, we find that the bulk of their holdings are concentrated in large-company U.S. stocks.

In future blogs, we'll explore what we mean by diversifying across different kinds of investments. But for now, think of a concentrated portfolio as the equivalent of many basketsful of plain, white eggs. Overexposure to one ingredient among in your financial diet is not only un-appetizing, it can be detrimental to your financial health. Lack of diversification:

  1. Increases your vulnerability to specific, avoidable risks
  2. Creates a bumpier, less-reliable overall investment experience
  3. Makes you more susceptible to second-guessing your investment decisions

Poorly diversified portfolios tend to generate unnecessary costs, lower expected returns and, perhaps most important, increased anxiety. Such a portfolio puts you in the position of trying to beat the market instead of harnessing its power.

As you seek to create healthy portfolios, consider that there is a wide world of investment opportunities available from tightly managed mutual funds that are designed to facilitate meaningful diversification. These funds offer efficient, low-cost exposure to capital markets all around the globe.

To best capture the benefits that global diversification has to offer, we advise turning to fund managers who focus their energies on efficiently capturing diversified dimensions of global returns.

In our previous blog, we explained why brokers or fund managers who are fixated on beating the market are likely wasting their time and your money. You may still be able to achieve diversification using such professionals, but your experience will be hampered by extraneous costs and distractions to your resolve as a long-term investor. Who needs that, when diversification alone can help you have your cake and eat it too?

In our January blog, we'll explore in more detail why diversification is sometimes referred to as one of the only "free lunches" in investing