Investment Consult

Are you as diversified as you think?

Just because you own a lot of investments, don't think you have all of the bases covered.

Lewis J. Altfest, PhD, CFA, CFP

A couple of years ago, a potential client asked my opinion of his investment portfolio—15 stocks in different industries. After doing a little research, I told him that too many of the companies were small firms with weak balance sheets, low returns on invested capital, and whose stocks had suffered a series of sharp price swings. Nine months later he returned to my office, his portfolio's value down by two-thirds. The decline had nothing to do with the debacle in the technology sector, which happened at about the same time. It happened because he owned lousy stocks and wasn't sufficiently diversified.

As I explained to my new client, you can't spread your bets properly without considering the following factors: the type of investment (stocks, bonds, real estate, etc.), its size (small, medium, large), investment style (value or growth), business sector and specific industry (health care and nursing homes, for example), and base of operation (domestic vs. international). By owning a variety of investments, you'll lower your portfolio's volatility and may even increase its long–term return.

The box to the right is a sample target investment allocation that takes into account each of the main asset categories. I'd recommend it for a moderately aggressive investor age 40 or older.

These percentages are only guidelines. If you're younger than 40, very tolerant of risk, or both, you can invest more heavily in stocks. To gain further diversification, you can add real estate, gold, international bonds, and specialty mutual funds—those that invest solely in Japanese companies or in utilities, for instance. Some of these investments can be particularly volatile, though, so don't buy them just for the sake of diversification. If you don't understand them and neither does your adviser, stay away from them.

As you saw with the client I mentioned earlier, owning a handful of individual stocks doesn't necessarily provide adequate diversification. That's why I recommend my clients buy mutual funds in a variety of investment categories. A typical stock fund owns more than 100 stocks.

Another benefit of investing through funds: You have a simple way to measure how similar they are to a broad index. For each of your funds, examine the "R-squared" figure. It measures the degree to which the fund mirrors a benchmark—the S&P 500, a "best fit index" (the Lehman Brothers Aggregate Bond Index for an intermediate-term-bond fund, for example), or both. An R-squared of 100 represents a perfect correlation. The smaller the number, the more the investment's returns will deviate from those of the benchmark.

If all of your stock funds have R-squared values of 80 to 100 compared to the S&P 500, they're probably very similar funds. To be properly diversified, your portfolio needs funds that correlate much less or not at all to one another, or to the S&P 500 and other major benchmarks.

Morningstar and Value Line both provide R-squared figures for the funds they evaluate. Fidelity Blue Chip Growth Fund, for instance, has an R-squared of 90 against the S&P 500. That close correlation isn't surprising, given that the S&P 500 is loaded with blue-chip stocks. Vanguard Health Care Fund, on the other hand, is a specialty mutual fund that owns a fair number of midsized companies in addition to large companies, both foreign and domestic. It has an R-squared of 19 against the S&P. That means it's unlikely to perform the same as the index or any fund that more closely follows the index.

Whether or not you change the investments in your portfolio, you ought to review it annually and rebalance it as necessary, to bring the allocations back into line with your targets. Keeping close tabs will prevent you from betting too heavily on one area of the market. Not only will you enjoy more consistent long-term returns, but knowing you have a sensible portfolio will help you sleep well at night.

The author, a fee-only financial planner, is president of L.J. Altfest & Co. ( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

Lewis Altfest. Investment Consult: Are you as diversified as you think?.

Medical Economics

2002;16:18.