Do You Really Know What It Means To Be 'Diversified'?

Matthew Cuplin |

I once heard someone explain “investment diversification” like this: It is used to make sure you never own too much of any one thing in your portfolio that you’ll make a killing on it or be killed by it.

The truth is investors do not always understand what they own. And that’s OK — it’s not necessarily their job to understand that in detail. Being truly diversified only multiplies that confusion at times, because you may own a little bit of a lot of things.

I think most investors would admit they need to, and should, be diversified. Right? They know they should own some stocks and some bonds. They should own some U.S. companies and some international companies. They should own some big, medium and small companies. The list goes on. That’s how you become diversified.

But here is a common problem advisors face with investors when helping them diversify. Those same investors are often conditioned to measure the ups and downs of the market based upon a very narrow snapshot of it, like an index. This is usually because that’s a common focus of news coverage.

I’ll explain more about that in a moment, but first let me address the elephant in the room. As a financial planner, I constantly tell clients they should focus on what really matters in their lives: family, health, friends, love, experiences, memories and so on. The last of which on that list should be the day-to-day (largely irrelevant) movements of the market.

But, because many people cannot help themselves and the news media panders to that “need” of watching the financial markets, I know it happens. Even worse, I know that some of those media outlets exaggerate the negative as that also plays to the very parts of our human nature that will keep us giving them more attention.

So it’s important that you understand as it applies to you, the diversified investor, that when you hear or read “the market did this or that,” your portfolio probably didn’t behave the same. That’s because if you have a truly diversified portfolio, then comparing it to a broad and generic measurement of the overall financial market isn’t accurate.

The “market” you hear referred to most generally on American TV or in the media is usually the U.S. stock market, not international. It’s also usually referring to some broad measure or index of it. And it’s usually only one fraction of the overall set of potential U.S. stocks one could own.

For example, maybe they are referring to the Dow Jones, which is a collection of only 30 U.S. ultra-large company stocks. Or maybe they are referring to the S&P 500, a measure of just over 500 U.S. large company stocks. Either way, it’s not a total depiction of what exists in a diversified portfolio.

Yes, a diversified portfolio is going to own things that are represented by the Dow Jones or S&P 500, but it potentially also owns a lot of things that are not. You may own midsize U.S. companies or even small U.S. companies. You may have developed foreign markets. You may have emerging foreign markets. You may own bonds of some sort, either from companies or governments. You’ll probably have some “cash-like” investments, too. You may own a lot of different things if you are truly aiming to be diversified.

Therefore, the key thing to remember is if you are truly diversified, you should not expect your portfolio to perform the same as “the market” you hear discussed on TV or read about online, both on the upside, but especially on the downside. You’re comparing your broadly diversified portfolio (apples) to a very small measurement of a piece of your investments (oranges).

My overall hope in expressing this is to help educate investors on understanding the information you are given on a daily basis in the media, knowing how it applies to your situation and understanding the implications. Financial planners spend a lot of time educating people on why they should tune out the media noise and focus on the detailed and diversified investment plan we believe all investors should have. And that’s part of a larger crafted financial plan. Because in the end, we know if we own good quality investments, remain diversified and have a plan, the markets — all of them — will do the rest.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.