5 Myths of Diversified Investments

A diversified investment strategy helps you manage risk while maximizing returns. By selecting diversified investments from different sectors, geographic regions and business sizes, your portfolio is better positioned to weather different economic storms and market conditions.

When you diversify correctly, your investments won't all react in the same way to market events. As some markets and investment types go down in value, others within your portfolio may be going up.

But just like any good thing, it's possible to overdiversify or to make mistakes in your strategy. Understanding diversified investments, avoiding the misconceptions and sticking to a smart approach will help you steer clear of any pitfalls and stay on the right track.

Here are five common myths about diversified investments and why you shouldn't believe them.

1You can't have too many investments

It turns out that simply adding more stocks, bonds or other investments to your portfolio won't automatically boost your investment performance. In fact, too many different investments could become difficult to manage. If they're in the same sector or industry, they might even reduce diversification. Instead, choose a few different investments in complementary sectors and industries.

2An index fund offers enough diversity

Not necessarily. Index funds offer some attractive features, such as passive investing with low effort, low management fees and easy access for a variety of investors. But the increasing popularity of index funds, which are set up to mimic the investments of a specific market index, has also increased correlation between underlying investments.

Higher correlation between investments means higher risk and lower diversification, because their values rise and fall together. That means they're less likely to offset or balance each other out if market conditions change and affect one portion of your portfolio. This is especially true for equities. Take extra care to review the underlying equities in index funds to prevent overexposure in one market.

3Once a well-diversified portfolio, always a well-diversified portfolio

This is another common misconception that could prove costly. As individual investments rise in value, they make up an increasing portion of a portfolio. This could actually decrease the diversification of the portfolio over time.

Minimize this effect by rebalancing your portfolio annually to sell some of your investments and meet your current asset allocation target.

4You don't need diversification if you have one good investment

Maybe someone you trust has shared how well one investment they've held for years has done for them. Or maybe you're satisfied holding one fund from your favorite investment firm. Although either might be an excellent investment, both are examples of underdiversification. This means your portfolio's risk factor hasn't been minimized.

If an investment sector performs poorly, or if a fund company goes out of business, your portfolio performance could suffer. Try to avoid basing your portfolio on just one sector or fund company to mitigate the risks of underdiversification.

5Holding multiple funds equals diversification

If your portfolio holds several similar funds, they could actually include the same underlying investments—say, North American stocks, or stocks in small companies. This may mean you have too much of your money in this type of investment.

You might also be paying double the necessary management fees. For example, say you hold Stock A in both Mutual Fund 1 and Mutual Fund 2. You're effectively double-dipping and paying a management expense ratio fee to each fund.

Instead, you might want to talk to an advisor about choosing funds that don't include overlapping underlying investments or introducing individual stocks to your diversified portfolio.

Take a smart approach to diversification

Understanding the pros and pitfalls of diversification in your investment portfolio can help you make wiser investment choices. Consider how each investment complements and correlates to the others in your portfolio. Avoid choosing too many investments or funds, and talk to a financial advisor for advice on your particular situation.