What Is Diversification, and Does It Work? – Part 2

by financialmom on September 23, 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.)  Part 2 continues with the concept of Overlap (thus the puppies picture).

Asset Allocation

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.

For starters, we believe overlap makes it difficult for the investor (and his or her advisor) to truly understand the asset allocation mix. How much money does the investor really have in large company stocks vs. small? How much in international stocks vs. domestic, how many growth stocks vs. value stocks, and so on.

Taxes

Another consideration is taxes. When one fund manager sells a stock that another fund manager happens to be buying, the overall portfolio of the investor hasn’t changed materially, but the transactions may have triggered a taxable event. And yes, it happens within fund families, not just between different fund families.

Hidden Costs

Lastly, stock overlap creates hidden costs within the portfolio that the investor doesn’t see, but that he or she may feel in terms of lower returns. All mutual funds may have costs associated with the buying and selling of securities within the portfolio that are borne by the investor.

While not identified in the prospectus, they may be found in the fund’s supplemental disclosure document. Investors must ask for this document, however, as it is not automatically sent to all investors.

So given these trading costs, we believe excessive trading is detrimental as these higher costs will likely result in diminished returns. We believe it’s particularly unfavorable, however, when multiple funds owned by an investor buy and sell the exact same stocks.

Benefit

So when building diversified portfolios, how do investors benefit by owning different asset classes? We believe very simply, when one asset class is down, another may be up or down, but not down to the same degree. Why? Because of the underlying stocks that comprise different asset classes, and the concept of the “correlation” between stocks.

(Stay tuned for Part 3 – the concept of Correlation.)

New Profile Pic 2599R What Is Diversification, and Does It Work?   Part 2Pamela 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 2Photo Credit – wsilver

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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