What Is False Diversification?

Today, I wanted to spend a little bit of time talking with you about what I call false diversification. Now, there are plenty of arguments out there among intelligent, sophisticated investors about what diversification actually means. Right? You've got the total market crowd. They argue that the more investments, right. The more companies you're invested in, the more diversified you are. Thousands of them. Great. Right. They'll often argue that capitalization weighting is ideal since it's the way the market allocates capital. It's the most diversified way for you to do so. Others will argue that you want to diversify your risks instead of just taking on market risk, maybe take on some small company risk and some value risk and some leverage risk. Others will argue for more of an equal weighted approach instead of capitalization weighted, like you see with something like the Vanguard Total Stock market fund, where 27% of your investment is invested in only 10 companies. You could spread your money across dozens, hundreds, or even thousands of stocks equally, so you have equal amounts into each investment. And then, of course, there's diversifying between asset classes, putting some money into bonds, real estate and international stocks and precious metals or crypto or whatever. Right. And diversifying across different asset classes. All of those people are right. Right. Sophisticated investors are going to continue to argue the merits of each of these approaches to diversification until the cows come home. But there's one thing that all sophisticated investors are going to agree on, but that many unsophisticated investors, and frankly, a bunch of people who call themselves advisors, are still getting wrong about diversification. It's called false diversification. And what is false diversification? Well, I saw a good example of it this week on the Bogleheads forum. And this poster said my brother had his advisor tell him that The S&P 500 is too concentrated and he needed to diversify better. The advisor had him in six different mutual funds. He sent me the sheet that showed the funds and allocations. I ran it through an analysis and saw the three of the six funds had significant investment in various Fang stocks, even though they weren't in that category. For example, the international and emerging markets funds had both Amazon and Google in them. In one of the US funds, FANG stocks represented over 45% of the fund. I showed my brother that his top 10 stocks represented a larger percentage of his full portfolio than The S&P 500 did. And that's just a classic example, right? False diversification is when you invest your money across different funds or managers, but the underlying investments are all the same. For example, a Novice investor might feel good to be invested in five different tech funds, but at the end of the day, those managers are all investing in the same stocks. The investor has added cost and complexity, but has not gotten any benefit for doing so. When those stocks go down, all the funds are going to go down. When those stocks go up, all the funds are going to go up in value. It seems like diversification, but when you actually look under the hood, it isn't. Some advisors out there put their clients into dozens of of different mutual funds and individual stocks. I prefer to think they're doing this out of ignorance, but it's entirely possible they're doing it on purpose to make that work seem too hard and complex for the individual investor to take on as a do it yourself project. Every time I see it, though, it's kind of a sign. It's obvious to me that that advisor needs to be fired. There's no reason for anybody to to own 30 different mutual funds. There are very few good reasons for anyone to own individual stocks. Throw both of them into a portfolio and it's frankly the mark of an incompetent advisor or do it yourself investor. So don't go for false diversification. Right? You probably don't need that many mutual funds in your portfolio. Lots of people have three, four, five funds. That's it. That's the whole portfolio. They own all the securities in the world. You can even add a tilt to small or value stocks or real estate or whatever you want to in your portfolio and still have fewer than four or five or six funds in the portfolio. You don't need 20 or 30. You certainly don't need 20 or 30 that are investing in the same investments. That's just false diversification. More cost, more complexity, no benefit. Don't do that.

The hosts of the White Coat Investor are not licensed accountants, attorneys or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.