Quizmaster, Doug Hutchinson, has come up with another great quiz. This time he discusses creating a meaningful and balanced diversification strategy.
Good luck!
Your friend Ben has been saving money and he has $10,000 that he would like to invest.
Ben owns 47 different mutual funds and he is considering investing his $10,000 in a 48th mutual fund.
"My goal is to be diversified," Ben tells you.
"You can never have too much of a good thing so adding the 48th mutual fund to my portfolio will get me evenmore diversified. The more holdings I have, the greater the diversification benefit that I'll receive."
Is it reasonable to expect that Ben will get a meaningful diversification benefit by adding a 48th mutual fund to his portfolio?
It is not likely that Ben will see a material diversification benefit by adding a 48th mutual fund to his portfolio.
Ben is wise to seek a diversified portfolio. Spreading your investments across various sectors, industries andinvestment styles with low correlations to each other can reduce the volatility of your overall portfolio.
However, the diversification benefit by adding additional securities increases at a decreasing rate as more and more holdings are added to a portfolio. In other words, the diversification benefit achieved by adding a 5th security to a portfolio of 4 securities is much greater than the diversification benefit of adding the 4,284th holding to a portfolio of 4,283 securities.
You can only reduce your portfolio volatility to a certain point. Once you reach this point, adding additional securities will not have a meaningful impact on the volatility of the overall portfolio.
Mutual funds own dozens or even hundreds of underlying securities. By owning a whopping 47 differentmutual funds, Ben already has exposure to thousands and thousands of securities. Adding a handful moreholdings to the pile is unlikely to produce a material diversification benefit.
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.