In our past post, “Time for a Spring Cleaning,” we mentioned the importance of building a well-diversified portfolio, but noted that many investors are confused about what real diversification is all about. An investor might think she is well-diversified if she holds a high number of mutual funds or individual securities. But if they largely represent U.S. large-company stocks, that’s about as diversified as the color choices for Henry Ford’s Model T, where the customer could “have a car painted any color that he wants so long as it is black.”
Today, we wanted to follow up with a closer look at effective diversification. Rather than reinvent the wheel, we’ll refer you to an excellent overview that already exists in the form of CBS MoneyWatch columnist Larry Swedroe’s post, “How to diversify your investments.” In his post, Larry describes the key components to real diversification and walks you through some basic models for building diversified portfolios.
Before you get out your portfolio construction toolbox, however, let’s revisit our favorite theme – elegant simplicity. Dimensional Fund Advisors’ core fund approach has taken the important concept of diversification and added an extra level of efficiency by taking care of pre-assembling much of the “core” diversification for us. This makes it easier to finalize a fully diversified portfolio with fewer individual components, which has the potential to lower trading costs within the funds as well as for the end investor.
Take that, Henry Ford.
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