Are you really well-diversified?
- Alan Lavine and Gail Liberman
Are your family's investments truly diversified?
Financial advisers too often complain that clients wrongly think their investments are well-diversified.
The most chilling examples of this miscalculation have involved employees of companies, like Enron, which went belly-up. Not only were employees out jobs, but because so much of their holdings were in company stock, their investments simultaneously got hammered.
Jim Cramer on his CNBC-TV show "Mad Money" has led a segment, called, "Am I Diversified?" In it, investors rattle off the names of five stocks. He then proclaims whether they're diversified. He does this because it's a good idea if you're going to own stocks to make sure they're in different sectors of the economy.
He's right. But even if you're well-diversified in stocks, you're not necessarily well-diversified. To be officially well-diversified, you must keep money in a host of other investments, like bonds and cash. You also want to own investments not only in the United States, but also abroad.
Recent research further documents that the most conservative investors may not be as diversified as they think.
A working paper by Columbia University Professor Gur Huberman, Ph.D. and Daniel Dorn, Ph.D., of Philadelphia's Drexel University, reported that risk-averse investors bought mutual funds more often than individual stocks. When they chose stocks, they generally purchased stocks with low volatility. The research suggest this may be a mistake.
The study examined trading records of 1,300 investors from January 1995 to May 2000 and also polled investors. The results: Conservative investors often limited themselves to a small number of familiar, similar stocks with similar volatilities.
Could you be among those who think investing in brand-name blue chip dividend paying stocks is a good way to diversify?
This may not always be the best idea either.
Of course, once you get your dividends, there's less chance of losing that money in a down market. Plus, most stock dividends are currently taxed at just 15 percent, rather than based on your income tax bracket, which can run as high as 35 percent.
However, Stanford University Finance Professor Stefan Nagel warns that households that get dividends are more likely to spend them.
A study of his suggests that you could be better off reinvesting your stock dividends in new shares of the company's stock or in other types of investments, like bonds, CDs and cash.
Historically, the reinvestment of dividends contributes about 4 percent to the total return of the S&P 500 stock market index. Stock price appreciation contributes 6 percent.
Don't think that just because you own a lot of mutual funds that you're well-diversified either. Consumer Reports Money Advisor in its March issue warns that more than half of all mutual funds own more than 100 stocks. Do you own too many mutual funds? You could be owning the same stocks or bonds--just paying more.
If your investments are in mutual funds, the publication suggests, consider seeing how www.morningstar.com categorizes each of your funds. If you have more than three funds in one of Morningstar's nine style categories, consider selling. Consider buying in a different category you don't already own.
Spouses Gail Liberman and Alan Lavine are syndicated columnists. You can purchase Alan Lavine & Gail Liberman's latest book Quick Steps to Financial Stability (QUE Publishing 2006) online at www.moneycouple.com or at your local bookstore. E-mail them at MWliblav@aol.com.
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