No Need to Break the Bank for Diversification

In considering the costs of portfolio diversification, remember the old bumper sticker, "If You Think Education is Expensive, Try Ignorance."

Indeed there are costs -- transaction fees, broker fees, and the overall issue of having sufficient capital to spread your money around sufficiently in the first place  -- to name a few. But the alternative can be significantly costlier.

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"The question is not how expensive it is to diversify, but how expensive it is not to diversify," Dennis Barba, managing partner of the Oxford Group, wrote in a note on the topic. "Individual investors continue to chase performance and hurt their returns by not being diversified."

"Too much emphasis is placed on beating the market as opposed to working with people to determine the exact range of expected returns that are necessary to fund their specific and unique financials goals, combined with how much risk (volatility) they can handle before their emotions take over," adds Barba.

At a time when investors are more often managing their own accounts online rather than working in tandem with an expert, portfolios have tended to become less diverse and more risk-oriented.

The results for the lucky investor can be meteoric, such as for those locked into the homebuilder sector earlier this year . But the fallout also can be catastrophic -- ask anyone betting that Bear Stearns   stock would finance their retirement before the company fell victim to the credit bench and was bought for a song by JPMorgan Chase  .

Yet some investors get scared off by the mistaken notion that purchasing stocks, bonds and funds across a wide swath of interests is cost-prohibitive for the typical retail investor. Not so, say money managers.

For Maximum Benefits, Think Long-Term

"There's no reason that diversifying a portfolio should cause an investor to incur a significant cost," says Matthew Rubin, director of investment strategy at Neuberger Berman. "The best way is to kind of own a long-term strategically diversified portfolio rather than trying to market-time and move in and out of asset classes -- to be long-term in nature, very strategic in nature. Owning a multiple asset-class portfolio tends to mitigate expenses over time."

On the other hand, those who seek diversity by continuously trying to find new places to put their money face substantial tax and fee costs, Rubin points out. Trading stocks can get costly for those shuffling in and out of various companies and funds.

For those who use brokers, each trade can run from $70 up, with $100 a common charge. Even online brokerages charge per-trade fees and set account minimums that vary. Plus, you rack up extensive tax exposure as you complete each transaction.

But how to avoid the temptation of dumping poor-performing issues without getting burned over the long term?

"As appropriate you have to rebalance to your long-term strategic targets," Rubin says. "We are in a period of significant volatility. As that volatility affects your long-term strategic requirements, you rebalance so you're back to strategic locations. Make sure you properly balance across multiple asset classes."

For example, as the market hit its late-year slump in 2007 many money managers advised their clients to pull back from stocks and increase their cash positions, with the result being a retreat in record-high levels in stocks and a surge in bond prices. With the stock market staging a tepid recovery in 2008, investors are now easing their way back to equities.

But most experts advise smaller-level investors -- with portfolios under $100,000  -- to stay away from picking individual stocks, period. Instead, they counsel a more conservative approach via proven mutual funds and exchange-traded funds that mimic the movements of high-volatility areas -- think commodities -- without the exposure of margin covering.

Some Practical Advice

Among the more popular diversification tools this year have been exchange-traded funds that track commodities, particularly metals.

The streetTRACKS Gold Shares fund has drawn tremendous interest, with a return so far this year of 6.4 percent and a 30 percent gain off its 52-week low. As investors have turned to gold as a hedge against inflation and the tumbling stock market, GLD has risen accordingly.

But its volatility -- the fund has dropped more than 8 percent in the past month -- serves only as a reminder of the importance of the need for still more diversification.

"I think this year's a good example," says Brian Gendreau, investment strategist at ING Investment Management. "For a while, gold and oil were all hedges against inflation and hedges against the stock market and high-yield bonds going down. That was a good hedge until last week."

Financial advisers are big on mutual funds to achieve diversification.

Tanous likes the Vanguard Energy Fund , which allows investors a safer play in the oil market. He also likes basic index funds, like those tied to performers in the Standard & Poor's 500, but says ETFs provide diversification with less expense and more flexibility when it comes time to sell.

On the bonds side, Rubin prefers higher-yield municipal and tax-exempt bonds as essential to any investor portfolio, especially when stocks suffer.

"In the troughs of the market, the less diversified you are the less chance you have to recover the losses given the volatility of equities relative to other asset classes," he says. "Typically, fixed-income bonds ratchet down your equity exposure and increase your fixed income."

Rubin recommends that investors think about their porfolio based on a four-to-eight year timeframe.

© 2009 CNBC.com