How diversified is your portfolio? And what can you do to improve your diversification?
Some people end up investing all over the place in order to diversify their portfolio, but it’s not working for them. What they are doing is called naïve diversification.
If your retirement plan offers a number of different investment choices, you may be tempted to divide your savings evenly among them. This is the classic case of naïve diversification. “I don’t know which fund is the best, so I’ll just invest in them all.” Sometimes you’ll end up with an asset allocation that isn’t all that bad; sometimes it will cost you a lot in poor performance. It could come down to what your company is offering.
The Federal Thrift Savings Plan has 10 investment options: 5 basic funds, and 5 lifecycle funds. The lifecycle funds—they can also be called target date funds—are just different combinations of the basic funds. When you start saving in the TSP, you’ll most likely be invested 100% in the G Fund. While you won’t lose money in the G Fund, you can expect better returns over the long run, along with more risk, from the other 4 basic funds. All five funds hold mutually exclusive investments—i.e. only the C Fund owns Apple*, and only the I Fund owns Toyota. Investing in 2 or more of the funds gives you more diversification, up until you own all 5 funds. Investing in an L Fund automatically means you own all 5 funds.
The magic of diversification
Real diversification is a good thing. It’s one of those mathematical principles that almost seems magical. Diversification is when you invest in 2 or more uncorrelated assets. Done right, it results in reduced investment risk, sometimes for the same or possibly higher return. Even if your overall return goes down slightly, you’re in better shape (mathematically) by significantly reducing your risk.
Correlation refers to how the investments track relative to each other over time. Does one go up when the other goes down? Or does one seem to follow the other? For example, The Home Depot and Lowes are highly correlated, unsurprisingly; buying one after already owning the other adds practically no diversification to your investments. Apple and Dunkin Donuts, on the other hand, are lightly correlated apparently (I’ll leave it up to you to suggest why). That means investors holding some amount of Dunkin Donuts stock in addition to Apple will achieve higher returns for less risk than if they put all of their money into just Apple.
Are you an Apple nerd?
I’m going to pick on Apple investors a little bit here for two reasons. First, it is a popular, well-known and fashionable company. Secondly, Apple is the largest company in the US by market capitalization. Buying Apple stock might make you feel like a tech-savvy or leading edge investor (does anyone out there feel as smart about buying, say, Simon Property Group?). But guess what? You probably already own Apple (and Simon Property Group), just like nearly every other mutual fund investor. As the leader of the S&P 500 Index, Apple is already probably the single largest holding in your portfolio—buying more Apple stock does not give you any added diversification.
The same goes for choosing funds in your retirement plan. You might choose to simplify your TSP savings by investing in the L 2040 Fund. That’s a great idea if you want someone else to manage your asset allocation. But then don’t go and shift some of your assets to the S Fund as well, thinking that small-cap stocks will improve your diversification. The L 2040 Fund already holds the S Fund! You’ve done nothing but shift your asset allocation away from what the TSP fund managers think is ideal.
Diversification in and outside of the TSP
You can achieve quite a bit of diversification inside the TSP. By owning the 5 basic funds you’ll have covered nearly all of the US stock market, the largest stocks in developed international markets, and the US market for investment grade bonds. You’ll also have the G Fund, a unique investment that is similar to inflation protected securities. To get more diversification than that you’ll need to invest outside of the TSP, but you can still keep the majority of your savings in the TSP. Examples of other asset classes to look at include: emerging markets, international small-cap stocks, foreign bonds, high-yield bonds, and real estate (through real estate investment trusts, or REITs). Outside of the TSP an investor can also diversify separately into stocks in the European and Pacific regions, rather than using the TSP’s single I Fund.
Remember that target date funds are not all the same with regard to their holdings or their “glide path”, the rate at which their allocation changes over time. The TSP L 2040 fund is different than the Vanguard Target Retirement 2040 Fund which is different than the Fidelity Freedom® 2040 Fund. At the same investment company they probably hold nearly the same investments, just in different ratios; in the TSP, the L funds all own the exact same stocks. For example, whether you invest in the L 2040 or L 2050, Apple is your single largest stock holding; investing in both doesn’t change your diversification, just your allocation.
What can you do?
For some people, a single target date fund is all they need to diversify. Others like the DIY approach. Do a little homework before you add another investment to your portfolio in the hope of gaining some diversification. Nearly every online financial site will tell you the top 10 holdings of any mutual fund. Do they look like the top 10 for another fund you already own? For index funds it’s even easier. Just check which index the fund seeks to emulate; another fund tracking the same index will have nearly exactly the same holdings and returns.
If you’d like some help, consider engaging a fee-only financial planner to give your portfolio a one-time check-up.
* Correction: originally this post said that Apple (AAPL) is held by the S Fund; in fact it is held by the C Fund, or common stock fund, which replicates the S&P 500 index.