FINANCIAL PLANNING FIB #5

I've spread your portfolio across eight funds so you get good diversification

Diversification is like mothers' milk in the finance industry. If you had to nominate one financial strategy that everyone can agree on, it's probably that diversification is a good thing. Most financial planning firms will have a brochure extolling the virtues of diversification, usually with a nice picture of eggs in different baskets on the front cover.

So what could be wrong with that? Nothing in theory. The problem is how to get diversification efficiently in practice.

The first thing to note is that spreading your money with a range of fund managers is not diversification; it's just spreading your money with a range of fund managers. Let's say you wanted to invest in a portfolio of Australian shares. You receive a statement of advice recommending that you invest in four funds: the ABC Gold Fund, the XYZ Bullion Fund, the Acme Precious Metals Fund and the Eldorado Yellow Metal Trust. Is that a diversified share portfolio? In terms of the gold sector, maybe yes, but you wouldn't have any exposure to the other 96% of the local stock market.

What if the statement of advice recommended eight different funds that covered nearly every sector of the stock market. For example, funds that specialise in growth stocks, value stocks, industrials, resources, gold, large caps, mid-caps and small companies. Surely you couldn't get more diversified than that?

That's probably true and it's quite common to see real-world financial plans with exactly this kind of recommended portfolio. But what has been achieved by covering every market segment with eight different fund managers?

Let's start with the growth and value stock funds. History and logic suggest that these funds are very unlikely to do well at the same time because they're like opposite poles on a magnet. The same is true for industrials and resources, and to a lesser extent large cap and small cap stocks.

All the planner has done here is create a portfolio which will almost guarantee you a return that's close to the market index. And if that's the case, why are you paying 2% a year in active management fees? You might as well invest in an index fund for less than half the price.