Here’s How Diversification Can Make Higher Returns

by Fern Alix LaRocca CFP® EA · 0 comments

Harvard Management Company which runs the endowment for Harvard University generated an investment return of between 7% and 9% for fiscal 2008. The S&P 500 index fell about 15% during the same time period. How did they do it? Here’s a hint. Can you say diversification? They invested in 11 non-cash asset classes only one of which is U.S. Stocks. You and I don’t have as much money as Harvard but we can take this valuable tip and put it to use in our portfolios.

Many of you know that it is important to have a diversified portfolio but knowing that fact and having one doesn’t always happen. Here are situations that I have heard clients say to me when they thought they had diversified:

I checked my 401K recently and it was well diversified
Wrong! Diversification takes into account your cash, IRAs, RothIRAs, and any other account that you may own. You should look at the diversification of all your holding not just one account.

I am well diversified. I have  stock index mutual funds, bonds and cash.
Wrong! Diversification is not just a mix of stock, bonds, and cash. You must be diversified over asset classes (large company or large cap, mid-cap, small cap, foreign, etc) and over asset styles (growth, income, core, equity income, etc.)

I have diversified into various large companies for income and low risk.
Wrong! You need to diversify over large companies as well as small companies and bonds for lower risk and income.

Even after Enron and all, many people still own a large percentage of their company’s stock — another big diversification no-no. It’s easy to keep things that you are familiar with like company stock or inherited assets long after they stop making money for you.

A report released by Citigroup found that a portfolio should have 25 to 30 different stocks to minimize stock specific risk. It found that only one in 10 stocks consistently out-performed the S&P 500 index over the past 20 years in any three-year period. In addition, a third of the stocks in the index underperformed the overall market by at least 15% or more at any given year.  This study confirms to me the benefits of using mutual funds to diversify and lower risk than individual stocks.

Want a money makeover? Be the first person to submit your portfolio anonymously and I will give you my opinion on how you can better diversify your holdings.

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