PETE THE PLANNER: Your portfolio might not be as diversified as you think

Dear Pete,

Can you settle a debate I’ve been having with my co-worker the last five years? He claims my 401(k) should be more diversified than the S&P 500, while I believe the S&P 500 is itself diversified given its 500 different holdings. His 401(k) account has around six different funds in it. It doesn’t make sense to me to be that diversified. Who’s right? If it’s me, I’ll send him a link to your answer.

—Mark, Fishers

There’s an art to gracefully telling someone they’re wrong, Mark. Your goal today is to assess whether I possess that particular ability.

When I got out of college, I would dine out for lunch every day of the work week. On Mondays, I usually ate a burger, Tuesdays were taco day (obviously), Wednesday was the day for pizza, Thursday was fried chicken sandwich day, and Friday was reserved for Kung Pao Chicken. As you might imagine, this type of eating took a toll on my temple.

During my first adult checkup with my physician, he told me I should be eating a variety of foods, and that variety would lead me to a lifetime of health. My doctor asked me to detail my weekly dining habits. I did. He stared blankly at me for what seemed like minutes. How long? I don’t know, but I easily could have made it through the drive-thru before he spoke again.

“I don’t think you understand what I mean by variety,” he whimpered.

The goal of diversification isn’t just to spread your market risk across different companies, but to make sure the companies themselves are significantly different from one another, and even more important, complementary to one another.

Obviously, the fates of the 500 companies within the Standard and Poor’s index aren’t explicitly linked, but companies of that size (large) and locale (domestic) typically move in relative lockstep. Whereas companies of significantly different sizes in significantly different countries can move differently, and potentially help smooth out market volatility.

If you’re interested in simplicity, which many S&P 500 investors are, you might consider looking at a target-date fund within your company-sponsored retirement plan. A target date creates a great deal of diversification by building a portfolio of indexes or funds. Each fund might have hundreds of stocks or bonds within them, but the types of companies are different from fund to fund.

Target dates are neither good nor bad, but they are ideal for people who value one-stop shopping. All target-date funds are not created equal, so be sure to examine the fees and ensure that the investment objective and glide path are in line with your personal investment objectives.

Even if you think domestic large-cap stocks most closely reflect your investment strategy, that doesn’t mean you should invest only in domestic large-cap stocks. I love cheeseburgers. But I occasionally have a salad. I love beer, but sometimes I drink water.

What I’m saying is, Mark, you’re wrong. You’re very, very wrong. Does that mean you received poor performance over the last few years? Absolutely not. In fact, your 401(k) likely outperformed your pesky co-worker’s. Does it mean you could have done better diversifying in a different way over the last few years? Not necessarily.

But it does mean, if the market eventually does what the market does (go down), you might get beaten up worse than a cherubic 23-year-old reviewing his fast-food fandom with his family physician.

One last note. In the search for reward, investors often ignore risk. And likewise, when investors worry about risk, they often don’t realize they’re on the verge of punting on any chance for a decent return. Proper diversification allows an investor to push the limits of reward while maintaining the proper level of risk.

Admittedly, it’s difficult to consider risk when the market’s climbed higher in the last 10 years than my cholesterol did in the summer of 2000, but now is the time to take action and make sure you’re properly diversified. Do it now, before it’s too late.

And don’t worry, I’ll send a link to your co-worker.•

__________

Dunn is CEO of Your Money Line powered by Pete the Planner, an employee-benefit organization focused on solving employees’ financial challenges. Email your financial questions to askpete@petetheplanner.com.