***Three Most Important Factors Are All Alike

written by A.T. "Al" Benelli, CFP, FIC

It is often said that the three most important factors in real estate are location, location, location. I assume the person who created this idiom was trying to impress upon all the belief that nothing else matters much. Location trumps all other factors. Well, if you believe that to be true, then in the world of investing the three most important actions may just be diversify, diversify, diversify!

Let’s say that you spend an afternoon at Philadelphia Park trying to pick the winning horse in a race. You choose the horse you believe has the greatest potential, and what do you do next? Bet all your money on the nose? Not unless you’re a very high stakes gambler. A $2 bet to “show” reduces your risk somewhat, but you’ve still got only one horse in the race. Betting on two or three horses in the same race would greatly enhance your chances of having a winner. Betting on every horse in the race would practically guarantee a winner, but would likely produce a negative cash flow because your winnings might not cover the amount you paid out. Get the idea?

Perhaps the biggest challenge facing investors is understanding what true diversification means and how to identify the separate “horses” in the overall investment race. Having 10 different stock mutual funds is not diversification at the investor level. I’ll argue that equity mutual funds, whether within the same fund family (like Vanguard, Fidelity, Schwab, etc.), or spread out over dozens of fund families — are all the same horse.

At the investor level, diversification means mixing assets across asset “classes” such as cash, income and growth and should include investments which are not tied to the traditional stock and bond markets that we have become familiar with, such as the NASDAQ or New York Stock Exchange.

Quite often investors will make the mistake of believing that if they are holding a myriad of funds — even those mixed among stocks and bonds — they have a diversified portfolio when, in fact, they may have little more than a “collection” of investments tied to a single market. Nick Murray, investment guru and founder of what is now the Financial Planning Association once called this phenomenon “di-worse-ification” — having so much overlap in an investment mix that a single shift in a single market can make significant changes in overall value.

Here is where professional advice can be most helpful, not just in identifying asset classes, but also in putting together a properly diversified mix across and within market sectors that can help reduce or even eliminate the non-systematic risk that exists in the investment world. The Nobel Prize-winning Post-Modern Portfolio Theory was built on the concepts of diversification and asset correlation. Sound confusing? Try this: Regardless of world economic conditions or market fluctuations, you can have at least one horse in the race that is a winner if your portfolio is truly diversified. Combined with a suitable cash reserve, one horse may be all you need to keep your financial plan on track.