The Wrong Kind of Diversification

Individuals managing their own assets receive no legal guidance on the standards for prudent investing.Fortunately, they can look to the Uniform Prudent Investor Act for guidelines. The act sets forth standards that govern the investment activities of trustees, and is currently the law in almost every state. While those standards do not apply to individuals managing their own assets, they do provide guidance on what the courts consider prudent investing.

Modern Portfolio Theory identifies asset allocation as the most important issue when investing and managing assets, because it determines well over 90 percent of the risk and expected reward of a portfolio. In fact, the act identifies the tradeoff between risk and return as the fiduciary's central consideration. The act incorporated one of the most important tenets of MPT in stating, "Because broad diversification is fundamental to the concept of risk management, it is incorporated into the definition of prudent investing."

Unfortunately, some investors make mistakes in their efforts to diversify risks. The reason is that some types of diversification are less effective than others, some are ineffective - and some can even increase risk.

WORSE AND WORSE

Probably the most common error made by individual investors related to diversification is purchasing several different mutual funds, each of which invests in the same asset class. Owning five different U.S. large growth funds provides only a minimal amount of diversification. This is a case of investors failing to understand that while they own different funds, all the funds are invested in the same basket - they are exposed to the same types of risks.

A similar error is made by many affluent investors. Not wanting to have all their eggs in one basket, they hire several investment advisor firms. This is a mistake on two fronts. The first mistake we have already discussed. Diversification, and the amount of risk in a portfolio, is no more determined by the number of advisors you have than it is determined by the number of stocks you own. Instead, as the academic research demonstrates, almost all of the risk of a portfolio is determined by its asset allocation.

The other mistake is that the hiring of multiple advisors can create several problems:

* Working with multiple advisors complicates the management of the portfolio.

* Economies of scale can be lost - advisors who charge by the amount of assets under management typically charge lower fees on larger portfolios.

* There is the potential for duplication of holdings, both in terms of individual stocks and asset class exposure. Thus, the portfolio may not be effectively diversified, and thus more risky than it should be. Also note that if the investor is using actively managed funds, the more advisors that invest in the same asset class, the more likely it is that you will be paying high active-management fees while owning a portfolio that looks more and more like a group of low-cost index funds. On the other hand, if the investor believes in passive management, there is no need for more than one advisor.

* If each advisor operates independently, there is the potential for inefficient tax management.

* If each advisor operates independently, style drift is likely to occur - the overall portfolio's desired asset allocation may not be maintained.

A FINANCIAL 'QUARTERBACK'

Having a well-thought-out investment plan is only one of the necessary conditions for success. (Among the other necessary conditions is having the discipline to adhere to the plan.)

The sufficient condition is to integrate the investment plan into a carefully constructed estate, tax and risk management (insurance) plan, because investment decisions and performance can impact other areas of the plan. For example, there might be a well-designed investment plan, but the financial plan fails because the primary breadwinner died without sufficient insurance (or was disabled without disability insurance).

To ensure that you have the greatest chance of achieving your financial goals, you should have a qualified wealth manager serve as the quarterback of your financial services team. That person should be responsible for coordinating asset allocation, estate, tax management and risk management (insurance) plans. And they should make the appropriate adjustments as your ability, willingness and need to take risk change over time. For example, better-than-expected investment performance may reduce the need to take risk, resulting in the ability to lower your equity allocation.

Better-than-expected investment performance can also impact your plans in conflicting ways. For example, higher-than-expected returns might allow you to self-insure risks that you previously bought insurance to cover (e.g., life, long-term health care, disability). It may also increase a family's ability to achieve other goals, such as donating to charity. On the other hand, it might increase your need for life insurance, if that is the most efficient way to pay estate taxes.

SUMMARY

While diversification is part of the prudent investment strategy, some kinds of diversification are more effective than others. Hiring multiple investment advisors creates the potential for inefficient portfolio management. And it may add unwanted complexity to your life, while increasing costs.

There is a simple solution that eliminates the need to hire multiple advisors. First, adopt a passive investment strategy. Second, hire an advisor who operates an "open platform" - they don't sell any proprietary products and are thus able to buy any product.

Third, hire an accredited advisor such as a CPA/PFS or a CFP advisor who not only provides investment management services, but wealth management services as well. Doing so will not only provide you the best chance of achieving your financial goals, but it will also simplify your life.

Fourth, make sure that the advisor provides a fiduciary standard of care. A fiduciary standard is often considered the highest legal duty that one party can have to another. This differs from the suitability standard present in many brokerage firms. That standard only requires that a product or service be suitable - it does not have to be in the investor's best interest.

Finally, you should make sure that you disclose all of your investment accounts (e.g., 401(k)) and all of your financial assets (e.g., stock options, life insurance, trusts) to your financial quarterback. That is the only way you can be sure that your plan is a well-integrated one. And it is the only way to be sure that you don't end up "di-worse-ifying" your portfolio.

Larry Swedroe is the author of The Only Guide to a Winning

Investment Strategy You Will Ever Need and the director of research for and a principal of both Buckingham Asset Management Inc. and BAM Advisor Services LLC, in St. Louis. His views are not necessarily those of Buckingham Asset Management or BAM Advisor Services.