What is false diversification and what are its consequences in a portfolio?

We all know the classic concept of diversification: “Don’t put your eggs in one basket.” But let me start by defining true diversification, and then I think it will be easier to understand what false diversification might look like. True diversification in an investment portfolio entails holding assets from different classes that tend to be non-correlated: that is, their prices tend to be affected in opposite or different directions by the same market or economic conditions. The classic, somewhat simplistic example is stocks and bonds; stocks, as shares of company ownership, tend to rise and fall with the perceived underlying value of the company. Bonds, on the other hand, which represent money loaned to the company, are primarily affected by the perception of a company’s credit-worthiness. In this way, stocks and bonds are non-correlated; their prices move in different directions for different reasons.

False diversification, on the other hand, happens when investors distribute their “eggs” among a number of different baskets, but don’t realize that the baskets are all very similar. In other words, though they may be holding a wide variety of assets, the assets all share similar characteristics—they are too closely correlated. As a result, what negatively affects one asset also negatively affects the others. So, when a portfolio is improperly or falsely diversified, everything tends to move in tandem—both up and down.

The benefit of true diversification, of course, is that it can help protect a portfolio against volatility—the stomach-churning ups and downs that can occur in the financial markets. When a portfolio is properly diversified, the investor should see that when one asset class is down, another may be little changed, or even up slightly. That is the great benefit of true diversification.
 

How can investors identify false diversification in their portfolios?

A qualified financial advisor can help you look at the assets in your portfolio and determine what they really are and which other assets they would be correlated with. So, for example, let’s say someone has five different mutual funds in their account, and they think that means they are diversified. After all, a single mutual fund typically invests in dozens or even hundreds of different holdings, right? So if I have not one, but five different mutual funds, I should be diversified, shouldn’t I? Eggs in lots of different baskets. But not so fast… what are the funds’ investment goals and objectives? If all five funds are trying to invest in dividend-paying stocks with growth characteristics, they are going to be highly correlated with each other. In other words, all the baskets containing your eggs are really the same basket; you aren’t well diversified. So, to really understand your level of diversification, you have to dig a little deeper than the surface to really grasp what makes up your holdings. Then, you can make informed decisions about how to gain true diversification.
 

How can investors correct false diversification?

It may be necessary to liquidate some holdings and purchase others; this is another place where a qualified financial adviser can help you by working with you to determine the least expensive way to move assets into various non-correlated classes. If you are holding mutual funds, it may be possible to transfer to another, non-correlated fund within the same mutual fund family without incurring punitive charges. But each situation is different, and investors should give careful consideration to not only transaction costs but also to tax implications. So, the best advice I can give is to urge investors to spend time with a qualified advisor who can help you assess where you are and, more importantly, where you need to go with respect to your goals and your risk tolerance profile.