Diversification is one of the most fundamental concepts in investment management. Effective diversification requires combining mutual funds that have a low correlation to one another.
Correlation is a statistical measure of how investments move in relation to one another and when. When investments move in the same direction at the same time, they are highly correlated. When investments move in different directions at the same time, the investments have a low correlation. Diversification of low correlating mutual funds reduce risk by not having all of a portfolio’s funds moving in the same direction to the same degree, and at the same time.
Many investors understand the logic behind diversification however, many often don’t implement or they don’t know how to implement an effectively diversified portfolio. One of the biggest mistakes many investors make is looking at a mutual funds return in isolation, instead of considering how its return could affect the overall performance of their portfolio. There is no benefit gained by investing in a portfolio of mutual funds if they all go up or down together at the same time. You could have a portfolio full of five-star funds and still be poorly diversified.
The accompanying shows the annual return from 2000-2018 of the Fidelity Blue Chip Growth Fund, the American Century Growth Fund, and the Vanguard Morgan Growth Fund. Individually, owning any one of these funds would have been a good U.S. large cap growth fund to own. However, owning all three funds basically provided no diversification as each funds annual returns funds during both the good, and bad years, were basically in lock step with each other.
When it comes to deciding which funds to include in your retirement portfolio, it is essential to look not only at a fund’s historical return, but how the historical return of the fund was produced. By diversifying among a mix of different types of funds that invest in different asset classes, risk can be reduced and losses from one category may be offset by gains in another. It is this dissimilarity in the pattern of returns that is likely to maximize the chances of investment success while keeping risk under control.
Martin Krikorian is president of Capital Wealth Management, a registered investment adviser providing “fee-only” investment management services located at 9 Billerica Road, Chelmsford. He is the author of the investment books, “10 Chapters to Having a Successful Investment Portfolio” and the “7 Steps to Becoming a Better Investor.”