When Diversifying, It's Asset Class That Matters

Portfolio diversification and asset collection are not the same thing.

College savings funds can include a variety of investments, such as stocks, bonds, and money market accounts.
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"If you're trying to beat the S&P by a percent or two a year, 25 stocks would still be considered a relatively aggressive active manager," he says. "Over time you might beat it, but in any one year with only 25 stocks you'd have significant volatility relative to your benchmark."

But a lot depends on asset class. "You could say 20 stocks in a very conservative dividend-paying portfolio is pretty good," says Goldman, "but you could also say 20 stocks in an aggressive small-cap growth fund is too aggressive."

[See Covering the Asset Classes.]

The bottom line: Try not to think of diversification as holding the biggest collection of securities you can assemble—a mistake many people make when choosing their 401(k) lineup. Some analysts call this the "1-over-n problem."

As Zemsky describes it: "You give people n choices, they put 1 over n amount in each one. I don't know if I'd use the word over-diversified, but if you give people too many choices they feel they don't have enough information and are afraid to pick any one particular choice. So they spread the money over every one of the choices."

That can produce a risk profile that the investor doesn't intend. As Goldman notes, if you equally weighted your equity holdings in small-, mid- and large-cap, you'd have a third of your equity exposure in a sector—small-caps—that represents only about 10 percent of the U.S. equity market.

"You'd have an implicit small-cap bet that you may not be aware of," says Goldman. "I can see my mother doing that—taking the money in her 401(k) and spreading it evenly among 12 funds [and thinking], 'Hey, I'm creating diversification!' But the more important decision is what asset classes they're in."