Getting true diversification

Getting true diversification

Host : OK, so if you basically like mutual funds, would investing in five or six be better than having just one?

David : It depends on whether or not these extra funds truly diversify your portfolio or not. If you have five funds that are mostly invested in the stocks of large US companies, you're wasting time and money. You'd be just as well off with only one fund that invests in similar assets.

I recently looked over a research paper which I prepared while earning my MBA-Finance degree. It was about diversification and how to obtain maximum return with minimum risk.

It was a complex paper with lots of Greek symbols, inverted covariance matrices, and years of statistical data. But all that stuff could be boiled down to the phrase "Don't put all your eggs in one basket."

Host : Well, that seems rather obvious...

David : Yes it is, but I wouldn't write the exercise off completely. First, by going through the exercise you learn how to combine different assets to reduce your risk and get a higher return. Now that's how you should structure your holdings.

And here's a corollary to this. Sometimes when you think you're getting diversification, you're really not.

I recently spoke with someone who had invested in a variable annuity. It seemed like he didn't understand what a variable annuity was, but he said his advisor thought it offered tax savings and diversification. Unfortunately, I don't think it was a good investment.