Think You're Diversified? Think Again.

Diversification is the mark of a good portfolio. Modern portfolio theory shows that for any given level of risk, the best performing portfolio is a diversified one. You can diversify your portfolio by buying a large number of individual stocks and bonds, but many of us choose a simpler method of diversification - we buy mutual funds.

A potential problem with that approach is that if you own more than a single mutual fund, you may be less diversified than you think. This is because it is possible that your funds are investing in overlapping sectors or even in the same individual stocks. Even though I invest our portfolio exclusively in highly diversified index funds, I recently decided to dig into our portfolio to determine whether we truly are diversified. I did so using e*Trade's recently launched portfolio analyzer tool.

The good news is that we do appear to be well diversified. However, even in our diversified portfolio there were some overlaps between funds. For example, Vanguard's Total Market Index (VTSMX), Vanguard's Growth Index (VIGRX) and the QQQQ ETF all contain a small percentage of Google stock. The result is that our portfolio contains double the amount of Google stock it would if we simply invested in the Total Market Index fund. The same is true for Apple, Cisco, Intel, GE, 3M and so forth. All in all, there is no real problem for our portfolio, since no stock accounts for more than 0.6% of our holdings. Still, you get the idea.

So how can you make sure that you don't over expose yourself to undiversified stock positions by investing in mutual funds? Here are a few rules of thumb:

1. Check Your Portfolio - using a tool such as e*Trade's portfolio analyzer made this process very simple for me, but you can achieve the same result by simply going through your fund prospectuses. If you find substantial overlaps, consider divesting of one or more of your funds.

2. Invest in Indexes - investing in Indexes should reduce the likelihood of dramatic overlaps, since index funds are, by nature, diversified and do not place sizable bets on specific stocks.

3. Avoid Sector Investing - if you concentrate your investments in a specific segment of the market, you are more likely to be investing in multiple funds that hold large, overlapping positions of a particular stock.

4. Don't Double Up - realistically, you only need a single mutual fund to cover each major asset class. Theoretically, you could invest in a total market index fund (e.g. VTSMX), a total bond market index fund (e.g. VBMFX), a total international index fund (e.g. VGTSX), and a real estate index fund (e.g. VGSIX) and your portfolio would be very well diversified. There is no need to select more than one mutual fund that covers a specific segment. The fewer funds you have, the lesser the risk of these funds overlapping and creating an under diversified position.

There is one more complicating factor: most of us have multiple accounts with different financial institutions - brokerage account, IRA, 401K, 529 and so forth. Checking for overlapping stock positions across multiple accounts is somewhat harder, but it is a worthwhile exercise. Even if your positions are well diversified in a specific account, you may have some overlapping, undiversified positions in some of your other accounts. You'll only know if you check.