What Is Diversification, and Does It Work? – Part 1

by financialmom on September 22, 2010

in Diversification, Investing, Investment Philosophy

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(This is a guest post, with content written by Symmetry Partners, LLC.  Our firm utilizes Symmetry Partners, LLC for investment management services.)

The past two years have raised many questions about the concept of investment diversification. Why does it appear to work some of the time, but not all of the time? How does an investor properly practice diversification? How many funds or securities must an investor hold to derive any benefit?

Defining Diversification

Introduced by Harry Markowitz, in the 1950s, diversification is the concept of not placing all of your eggs in one basket, but rather spreading your investment dollars into a variety of asset classes in an effort to increase returns for a given level of risk.

Groundbreaking research that earned him the Nobel Prize in Economics in 1990, Markowitz’s findings have had a significant impact on how people have invested ever since.

So while generally accepted as a fundamental of investing, we have found no hard and fast definition within our industry about what constitutes adequate diversification. It tends to be practiced differently from one firm to another; one investor to another.

Some investors might buy two or three mutual funds thinking they have diversified, while others may think that four or five funds are sufficient.

Asset Classes Are A Key

Regardless of the number of funds one chooses to own, in our opinion, the most important aspect of building a diversified portfolio is for the investor to own many asset classes. This means exposure to domestic large and small company stocks, as well as the stocks of international mature markets, and stocks from emerging market economies.

Additionally, because we believe the majority of investors lack the risk tolerance required for an all-equity portfolio, we feel most portfolios should have an allocation to high quality, short-term bonds as a means to mitigate equity risk.

What Investors Do

Unfortunately, what we have found, however, is that when investors attempt to diversify, they frequently end up holding several funds that have many of the same stocks. This creates needless overlap in their portfolios, and may result in some unintended consequences.

(Stay tuned for Part 2 – the concept of Overlap.)

New Profile Pic 2599R What Is Diversification, and Does It Work?   Part 1Pamela Otten is CEO of Pamela Otten LLC, a Registered Investment Advisor. She loves to work with women business owners and entrepreneurs, and women in transition due to job change, death, or divorce. Pamela will help you set and reach your financial goals, educate you to understand your investments, and teach you how to do more charitable giving. Pamela is a Qualified Kingdom Advisor (www.kingdomadvisors.org), trained and committed to integrating biblical principles with her investment advice.

cc smallest What Is Diversification, and Does It Work?   Part 1Photo Credit: Mrs Logic

Financial Planning, Investment Advice, and Investment Management provided through Pamela Otten LLC, Registered Investment Advisor.

The opinions voiced in this material are for general information only, and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, please consult your financial advisor prior to investing.

Content written by Symmetry Partners, LLC. Our firm utilizes Symmetry Partners, LLC for investment management services. Symmetry Partners, LLC, is an investment advisor registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. All data is from sources believed to be reliable, but cannot be guaranteed or warranted. No current or prospective client should assume that future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this article will be profitable. As with any investment strategy, there is a possibility of profitability as well as loss. Please note that you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Symmetry Partners.

The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as investment advice or a recommendation of any specific security. Past performance does not guarantee future results.

Higher potential return generally involves greater risk, short term volatility is not uncommon when investing in various types of funds, including but not limited to: sector, emerging markets, small & mid-cap funds. Risks for emerging markets include risks relating to the relatively smaller size and lesser liquidity of these markets, high inflation rates and adverse political developments. Risks for investing in international equity include foreign currency risk, as well as fluctuation due to economic or political actions of foreign governments and/or less regulated or liquid markets. Risks for smaller companies include business risks, significant stock price fluctuation and illiquidity. Real estate investments are affected by changes in real estate values, property taxes, interest rates and regulatory requirements and are subject to heavy reliance on cash flow and concentration in a small number of projects or single sector. Investing in higher-yielding, lower-rated bonds has a greater risk of price fluctuation and loss of principal income than U.S. government securities, such as U.S. Treasury bonds and bills. Treasuries and government securities are guaranteed by the government for repayment of principal and interest if held to maturity.

Diversification seeks to reduce volatility by spreading your investment dollars into various asset classes to add balance to your portfolio. Using this methodology, however, does not guarantee a profit or protection from loss in a declining market. Mutual funds are sold by prospectus only. Investors should carefully consider objectives, risks, charges and expenses carefully before investing. The fund prospectus contains this and other important information. Investors should read the prospectus carefully before investing. For a copy of the prospectus contact your financial advisor.

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