Robin Thurston, VP, Global Director of Research, is filling in for Don Cassidy today on "Business for Breakfast" 1060 KRCN Tuesday - Are You Diversified?

Tuesday, November 1, 2005

A. Well, I thought I would break down the whole concept of diversification a bit more and give a few hypothetical portfolio examples for the audience. Most individuals believe if they own a mutual fund or multiple mutual funds they are well-diversified. Basically, this is true compared to owning a single stock or a couple of stocks, but as your portfolio grows there are still a few things you might want to watch out for.

Q. Give us an example.

A. Sometimes when investors start out investing, they pick an individual fund by name--such as Janus Twenty, which has strongly outperformed over the past ten years. This very-focused or concentrated portfolio has done extremely well in up and flat markets, but in down markets it does not fare as well because of the concentration.

Q. So, are you saying investors should review the concentration of stocks in their fund or funds?

A. Absolutely, especially if they own only one fund. As investors increase the number of funds they hold this risk decreases, but there are other diversification risks.

Q. What might those be?

A. When a particular fund family outperforms, investors flock to it and purchase multiple funds from the same fund family.

Q. But, Robin, we all like quality brand names. What are thediversification risks?

A. Let's say Investor A invests 50% of his/her portfolio in American Funds' Washington Mutual and the other 50% in American Funds' American Mutual. The investor would have plenty of diversification in terms of the total number of stocks owned but might not realize there is now too much exposure to certain sectors and stocks.

Q. In this case, which sectors and stocks would the investor have too much exposure to and how could that be corrected?

A. Investor A would have too much exposure to value stocks, sectors like financial services and health technology, and individual securities like GE, which would represent almost 3% of this investor's portfolio.

The investor could correct this by first making sure when selecting a mutual fund in the same fund family that it is not in the same classification. In the case above both funds are value funds and both tilt toward large-cap stocks.

Q. Would this still be a risk if Investor A had selected one of the American Funds and Janus Twenty?

A. It would still be a risk if one product is from Janus and one product is from American Funds, especially if both products are in the same peer group--such as value. But, in the scenario you just gave me Janus Twenty is a growth fund, so the investor would be more diversified in terms of growth versus value but would still potentially need to invest in a small-cap fund or international fund to further diversify the equity portfolio.

Q. So, for diversification are there other things investors should lookout for?

A. Both of my hypothetical portfolios are 100% equity. So, while they are diversified in terms of the number of total stocks held and growth versus value, they are not diversified among other asset types like bonds, money markets, or real estate. It is essential for investors to not only diversify their portfolio at the individual security level but also at the classification level and then at the broader asset-type level, based on individual goals and objectives.

Q. Wow! Are there products investors can buy that help them achieve this diversification without doing all this homework? What about the S&P 500 or some other index fund? These products are diversified, right?

A. I'll answer the second question first. Index funds are more diversified than traditional actively managed funds because they are trying to represent the whole market. But, because they are market cap-weighted, often the top 20 or 30 stocks represent more than 50% of the total index, and this really drives performance. Because of this the S&P 500 is really just a large-cap index that gives an investor access to both growth and value stocks, but it truly isn't diversified in terms of small-cap or international stocks. It definitely wouldn't give an investor any diversification into bonds.

The answer to the first question is, yes. There are a lot of new developments in the mixed-asset categories such as life cycle funds, which give an investor exposure to bonds as well as equities and in many cases do a good job of diversifying a portfolio across the types of bonds and equities. The result is that the investor gets a truly diversified portfolio with just one fund.

Q. So, what should investors remember?

A. First, determine if you want to do all this homework. If not, perhaps a life cycle fund will fit your needs. Or you could perhaps see a financial planner.

Second, if you do want to do the homework and you are just starting to invest, make sure if you buy a single fund that it isn't too concentrated.

Third, if you are going to invest in multiple funds, determine the asset type and the appropriate mix based on your investing time horizon.

Last, once you've determined the asset types, make sure you review the funds' classifications before you invest to ensure you are properly diversified within the asset type.

Good luck investing and stay diversified!

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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).