The dangers of over-diversifying your portfolio

@Money September 16, 2011: 12:53 PM ET

NEW YORK (Money) -- My IRA rollover account is already diversified across a wide range of low-expense investments (including some Money 70 funds), but I'm considering diversifying even more, perhaps global bonds, mid-caps, REITs and commodities. How far should I split the atom in terms of diversification? -- K.S.

Diversifying your investments to dampen swings in the value of your portfolio is a good move anytime. But it's especially important these days when market movements can be so extreme.

At the same time, though, you don't want to abuse this time-honored strategy. For example, some investors today are shifting big chunks of their portfolios into gold, Treasuries or other investments in the name of diversification, when in reality they're just trying to time the market or move into an asset class they hope will perform better in the near term.

Others look around at the plethora of investments available today -- mutual funds that track every sector of the markets, ETFs that give entrée to precious metals and commodities, hedge funds that employ all manner of arcane strategies -- and think diversification means helping themselves to every course on the smorgasbord. If more equaled better, that would be fine.

'Is my stock portfolio truly diversified?'

But these investors often end up with a disorganized hodgepodge of investments that can be difficult to manage and expensive to maintain.

So how can you get the benefits of diversification -- solid performance without taking on extra risk -- without overdoing it and undermining those benefits? Here's my three-step guide to getting the right amount of diversification.

1. Get your asset allocation act together. More than any other factor, the way you divvy up your money between stocks and bonds will determine your portfolio's performance.

So before you start looking to expand your investing horizons, make sure you've got your basic stocks-bonds mix right. The goal is to tailor your asset allocation to your investment time horizon and stomach for risk.

If retirement is decades down the road, you've got plenty of time to recover from big downdrafts. So you can afford to lean toward stocks for their superior growth potential.

But if you're retired or closing in on retirement, you don't want to suddenly see your nest egg downsized by 20% or more. That argues for a larger cushion of bonds and cash.

I'm in 15 mutual funds. How should I simplify?

Although people have touted various rules of thumb for setting your asset allocation, the truth is there's no master formula. But you can come up with an overall blend that makes sense for you by first checking out our MONEY 101 lesson on asset allocation, and then trying different combinations of assets in online tools like Fidelity's Retirement Quick Check, T. Rowe Price's Retirement Income Calculator and Morningstar's Asset Allocator.

2. Cover the basics. Once you've got a suitable stocks-bonds mix, you want to be sure you're sufficiently diversified within those two broad asset classes.

Reasonable people can disagree on what constitutes adequate diversification. But in the case of stocks, at the very least you want a full complement of U.S. equities -- that is, small-, mid- and large-caps that represent all industries.

The same goes for bonds: you should have the full spectrum of investment-grade issues, including government, mortgage-backed and corporates in a range of maturities.

You can achieve this level of diversification by mixing a variety of individual stock and bond funds. Or you can do it the easy way with two funds: a total stock market index fund and a total bond market index fund. (If you're investing in taxable accounts, you may also want to consider a municipal bond fund.)

Frankly, if you do no more than this, I think you'll be fine.

3. Proceed with caution when diversifying further. If you're willing to put in some more effort, you might be able to earn slightly higher returns with no extra volatility (or get the same return with less risk) by investing in some other asset classes.

But the trick is to reap the potential benefits of more diversification without mucking things up. The place to start is with some exposure to foreign stocks.

You could limit yourself to the shares of companies in foreign developed nations by buying an index fund that tracks the MSCI EAFE index.

But if you want true international diversification in an increasingly global world, you might as well go with a total international stock index fund.

Am I saving enough to retire with $2 million?

That way you not only get shares of the developed world, but fast-growing emerging economies as well. I've never been a big advocate of diversifying into foreign bonds as the extra return potential for anything other than highly volatile emerging-market issues isn't all that enticing.

Plus, there's no real equivalent to a total international stock fund for bonds that allows for easily accessible broad foreign exposure. But if you're convinced you need foreign bonds, we include a broad actively managed international bond fund in our MONEY 70.

I can also see making REITS, mutual funds or ETFs that specialize in real estate securities a small part of your portfolio (say, 10% to 20% of your stock stake).

Real estate can act as an inflation hedge, plus it can dampen the swings in the value of your portfolio as real estate prices typically don't zig and zag in unison with stock prices.

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You might also consider adding a comparable portion of TIPS to your bond holdings for protection against rising prices. At this point, though, you really need to tread carefully, as you're getting into diminishing returns territory.

One can also make a case for adding a small dollop of commodities and/or gold via funds or ETFs. But frankly, despite some impressive gains in recent years, I'm not convinced they're worth the extra effort over the long run. As I wrote in a recent column, adding both REITs and commodities only slightly enhanced performance over the past 20 years.

If you do decide to buy commodity or gold funds in a taxable account, you should be aware of some quirky tax issues.

Bottom line: once you've got a well-balanced portfolio of domestic and foreign stocks and bonds that's appropriate for your age and risk tolerance, you should be getting most of the benefits of diversification.

If you want to go for more diversification gusto, fine. But go slowly. Sometimes doing more creates greater potential for harm than good. To top of page

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