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Don't Fall for Fake 401(k) Diversification

NEW BERLIN, Ill. (TheStreet) -- Sometimes we fool ourselves. Sometimes we think we're doing the right thing, when in fact the result is that we're not at all doing what we think we are.

I'm talking about your investment diversification. When you started your account, you were probably dazzled by the array of choices: a stable-value fund, three large-cap stock funds, a midcap stock fund, an international stock fund and two different bond funds. Recalling an article you read somewhere, or maybe your co-workers talking about around the water cooler, you knew you needed to split your investments among many allocation options. Wanting to do this diversification thing right, you split your 401(k) contributions with one-eighth in each of the funds available. You're well-diversified now, right?

Not even close, bucko.

Just because you have investments split among several funds doesn't mean you're diversified.

Just because you have your investments split among five (or seven, or nine or what have you) different investment choices doesn't mean you are diversified. Recently I reviewed a 401(k) account in which the participant had chosen, all within the domestic equities class, eight different mutual funds. All eight were fine funds, with relatively low expenses and good diversification.

The problem is that the eight choices made were roughly equal to one: a total stock market index choice. The participant could have accomplished the same result by choosing only one fund, greatly simplifying the account and, as it turns out, reducing internal expenses dramatically.

The real problem though, is that the participant had not allocated any of the account to fixed income, or international equities, or real estate, or any other asset class that gave the account true diversification.

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