Sunday, November 21, 2010

Can you over diversify your portfolio?

Every investment expert will tell you the same thing: Be sure to diversify your investments. And really, it’s just plain common sense – limit the type of investments you make and they’re easily squished by a single bad market cycle; but diversify your investments among all asset classes – cash, stocks, bonds, mutual funds and fixed-income investments -- and your chances for loss are radically reduced while your opportunities for long term growth are vastly enhanced.
But is it possible to add too many investments to your portfolio so that you actually begin subtracting from portfolio performance instead of adding to it? The essential answer is ‘absolutely’ – which is why the key is to understand the objective of diversification and how it applies to your portfolio.
The basic purpose of diversification is to control risk. The market goes up and down; it always has and always will. But making emotional buy and sell decisions in response to dramatic market moves is one of the biggest threats to the well-being of any investor’s portfolio. The solution is two-fold: diversify to cushion your portfolio from regular market ‘spikes’ and ‘corrections’ and stay the course to flatten out inevitable market fluctuations.
By combining investments with different return patterns, you reduce the variability of the portfolio as a whole. Look for investments that perform well at different times – that way, some parts will produce above average returns while other parts may be producing below average returns … but the combination of all parts will create a portfolio with relatively less risk overall.
But be sure you are really diversifying. As long as you add elements to your portfolio that are truly different, you are diversifying and there is a benefit to your portfolio. The real risk is adding things that are not diverse – such as adding another petro stock to your existing array of petro stocks, which has no risk-minimizing benefit.
Diversification is more important than the number of investments you hold. The return on your portfolio is simply the weighted average return of each part of your portfolio taken together. Ten mutual funds returning 8 per cent will deliver a portfolio return of 8 per cent – exactly the same as if you held five of those funds … or one. The key is how consistent will that 8% return be over time. A diversified approach smoothes out the bumps caused by market volatility ensuring a more consistent return over time.
The bottom line is this: portfolio performance is dictated by investment choice … not investment quantity. Talk to your professional advisor about designing and constructing a well-balanced, effectively diversified investment portfolio that will meet your financial objectives and match your risk comfort level and time horizons.

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