Bottom Line/Personal: As an investor, you know that you shouldn’t put all your eggs in one basket, so you’ve got your money spread around a number of stocks or funds—maybe a great number of stocks or funds. And you can relax, because if part of your portfolio goes south, another part will do OK, right? Wrong. You are not nearly as diversified as you think, according to a wise investment manager, who is my guest today.

I am Steven Kaye, editorial director of Bottom Line Publications, and this is Bottom Line On Your Money, where our experts help you create, invest and protect your wealth.

Today I’m speaking with Vahan Janjigian, PhD, CFA. Vahan is editor of the MoneyMasters Stock Report newsletter, chief investment officer at Greenwich Wealth Management and author of two books, including Even Buffett Isn’t Perfect. Vahan is a legendary stock picker, but besides that, he has taught money management and financial theory, so he understands the big picture for average investors.

Vahan, welcome. Thank you for coming out for Bottom Line viewers. We’re talking about diversification, basically, and it’s not thought of as a very hard thing to do—but you’re saying that most people are not as diversified as they think. Why is that?

Vahan Janjigian, PhD, CFA: That’s a good point, Steve. A lot of people think they’re diversified because they own a lot of stocks, so they focus on the number…or they own mutual funds, which already are fairly diversified, so they think they have diversification there. But when they look very carefully into exactly what they own, they could find out that perhaps they’re not as diversified as they thought.

For example, if you own let’s say an S&P 500 index fund, you have a lot of exposure to some of the biggest stocks in the market because that’s a capitalization-weighted index. And then if you also own stocks like Apple and Microsoft and Intel, you’ve basically doubled up on that exposure to the same stocks. So it’s very important to look at what’s in the funds that you own and also what individual stocks you own.

Some people, for example, end up buying too many stocks from the same industry. This was something that I saw back in the late 1990s, when we had the technology boom. A lot of people bought only the biggest names. In fact, my secretary at the time had a lot of exposure to only four stocks—Intel, Microsoft, Cisco, and Dell. She asked me to look at her portfolio—she had over 20 stocks in her portfolio, but something like 80% of the money was invested in only these four stocks. They’re all technology companies.

It is very important to focus on what industries these stocks are in and whether you already have exposure to them in the many mutual funds that you might own.

Bottom Line: This sounds like a little bit of a tall order for the average investor, because when you think about it, there are many ways to look at diversification. You mentioned capital size…the size of the company…whether a company is foreign or domestic…there are small companies, mid-sized companies, large companies…and then there are industry sectors. So heads are spinning as we talk about this. How can you narrow down the factors that you really can and should focus on?

Janjigian: Diversification can actually be a very complicated affair, because it involves mathematics. When we talk about portfolios being diversified, what we’re really talking about is the correlation coefficients between stocks and those portfolios.

The good news is that you don’t really need to do that, because a lot of it is common sense. For example, in the extreme case, if you own only one stock, you’re obviously not diversified, so it would make a lot of sense to add a second stock to your portfolio. But if the one stock you own is Ford, it wouldn’t make much sense to buy General Motors because those are two companies that are exposed to the same risk factors to a large extent. So you want to make sure that you have companies from different industries in your portfolio.

Another rule of thumb is that the more stocks you add to your portfolio, the more diversification you get. But you don’t really need to create your own index fund. You want a good number of stocks in the portfolio, but you want to make sure they’re from different market capitalizations, different industries.

Bottom Line: Meaning different sizes.

Janjigian: Different sizes. You want large-cap, small-cap…you want growth stocks…you want value stocks…you might want some international stocks. So there are many ways to diversify without actually creating your own mutual fund.

Bottom Line: What if someone just wants to diversify instantly with some kind of preset fund or group of stocks? You mentioned the S&P 500 is far less diversified than many people think it is. Is there an index out there…or is there a quick way to do this for the average investor?

Janjigian: What I recommend to people who want to do that is buy an S&P 500 index fund, buy perhaps an S&P 400 index fund—that’s a mid-cap index fund—and then you can also buy something like the S&P 600 index fund, which is a small-cap index fund. There are also mutual funds that track other indexes, like the Russell indexes, which give you quite a bit of exposure. But keep in mind that most market indexes are market capitalization–weighted.

Bottom Line: Just to be clear, what that means is the larger the company is, the greater its representation in the index.

Janjigian: Absolutely. That’s right. So if you bought the S&P 500 index fund, you will have a lot of exposure to Apple, the largest market-cap company. So you need to take that into consideration as well.

Bottom Line: And what about alternative types of investments, like gold and real estate and emerging markets? Are they on your radar?

Janjigian: They are, but if you’re talking about total diversification, you need to take those things into consideration. You need to take into consideration commodities. Currencies, for example. If you’re talking about diversification within asset classes, that’s also very important. My focus is primarily stocks, so I want to focus on diversification within the stock class.

Bottom Line: Let me throw something at you that a lot of people believe, and that is the longer your time frame, the less important it is for you to be diversified, because you have more time to make up for problems. True?

Janjigian: I would certainly agree that you could be overly diversified, so you don’t want to be too diversified. And if you do, if you really want extreme diversification, I would say don’t even buy stocks at all—just buy an index fund.

Bottom Line: OK, so the takeaway here is take a good look at your portfolio, and don’t assume that just because you have index or index funds in there, or many stocks, that you are diversified. You have to look at sectors and cap sizes and other things to make sure that you do have true diversification. Thank you, Vahan.

Janjigian: Thank you, Steve.

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