Weighing the pros and cons of portfolio diversification

Don't put all your eggs in one basket!

This cliche is a central tenet of financial planning and sensible investing. When some of your assets decline in value, you want others to appreciate. The more baskets you have, the less anxious you'll be about your eggs when a basket or two tumbles.

Diversification is a good thing, and building a diversified portfolio has never been easier for individual investors. The range of products now available offering exposure to everything — from real estate and gold to emerging stocks and hedge fund trading strategies — is enormous.

The selling point for a new fund or investment strategy vehicle is very often that its returns won't move with the traditional stocks and bonds that make up the bulk of most people's portfolios.

There can be too much of a good thing.

"Diversification is a great tool to deal with the uncertainty of investing, but most people overcomplicate things because of the access they have to so many strategies and products now," said Donald Bennyhoff, a senior investment strategist with Vanguard Group. "Just because there [are] more tools in the box, it doesn't mean people have to use them all."

While most financial advisors feel that the simple 60/40 allocation between U.S. stocks and bonds doesn't provide enough diversification for most investors anymore, they also think the expanding choice now available to investors cuts both ways.

"We have prospective clients come in with so much stuff in their portfolios, they don't [know] what they own," said Ron Carson, founder and CEO of Carson Wealth Management Group. "That's dangerous diversification."

Carson, a certified financial planner, does believe that in the current environment, investors need other sources of return that aren't correlated with stocks and bonds. While bonds have traditionally been seen as ballast for the equity side of portfolios, they may not hold up well going forward.

"Stocks and bonds can decline at the same time," Carson said. "We could see stocks come down as interest rates rise. People can't do what they used to do."

Since the financial crisis, Carson has developed a number of specialty strategies, including managing rental properties, buying health-care royalty streams and writing covered call options to help diversify his clients' mix of returns. "These strategies have been a godsend in this environment," he said.

For the most part, individual investors get diversification across geographic markets and asset classes through mutual and exchange-traded funds. The options are plentiful.

While U.S. investors have traditionally been heavily weighted toward domestic stocks, the flows into international equity funds have been very strong this year — until recently.

Investing in non-U.S. markets has become a lot easier and, despite foreign stocks not keeping with the U.S. indexes, advisors think diversifying across global markets makes sense.

"Foreign stocks have detracted from our performance, but we still like them in a portfolio," said Barry Glassman, CFP and founder and president of Glassman Wealth Services. "We believe in broad-based, low-cost diversification."

Glassman uses Dimensional Funds, a family of low-cost mutual funds marketed to financial advisors, for his core domestic and international equity exposures.

Glassman suggested investors need to be wary of buying too many funds that have overlap in their investment holdings.

"People chase returns, and when they do, they can end up with a lot of funds that have done well together," he said. "They end up being less diversified than they thought."

Vanguard's Bennyhoff suggests that individual investors who don't want to spend a lot of time and effort vetting investment funds keep it simple. "You can be diversified without owning dozens of mutual funds and ETFs," he said.

Four broad-based ETFs offered by Vanguard — Vanguard Total Stock Market, Vanguard Total International Stock, and Vanguard Total International Bond — give exposure to the total U.S. and international stock and bond markets. "Some people think it's simplistic, but those four funds offer broad global diversification at a very low cost," Bennyhoff said.

When it comes to diversifying with alternative asset classes, Bennyhoff also thinks investors should be wary of buying into the latest alternative mutual funds or ETFs tracking different assets. "Costs become a bigger consideration when you start looking at other asset classes," he said.

Vanguard has yet to offer any alternative mutual funds to retail investors, in part because the costs of such funds are so high. "You also have to be careful how you get exposure [to those assets]," added Bennyhoff. "It's not just the strategy that matters but the implications of it."

Taxes can also be an issue in some cases. Returns on ETFs that buy and sell gold, for example, are taxed at a 28 percent rate as income from collectibles. There is also the complication of understanding alternative investing strategies. A rule of thumb often cited by investment advisors is not to invest in things you don't understand.

"Investors get overwhelmed," Bennyhoff said. "If they have a lot of moving parts in a portfolio and things don't work out, it's hard for them to stick to their strategies.

"When they keep it simple, it's easier to maintain and rebalance a portfolio and stick with their investing plans in times of turmoil," he added.

Investors may continue to be tested on that front.

— By Andrew Osterland, special to CNBC.com